Valuation is the method of determining what an asset is worth. The price, on any given day of a stock, is how the market is valuing that asset. Your ability to look at various metrics when coming up with a valuation will determine if you can do a better job than the market at determining what an asset is worth. If you can outwit the market, you make profits. If you can’t, you underperform the market or lose money.
Some methods of stock valuation are the following: price to earnings (PE) multiple versus growth, earnings yield versus fixed income yields, and modeling out free cash flow projections and discounting them back to present value. You can also compare various metrics with competitors if you’re looking at an individual stock. The best comparisons for the whole market of a country would be other countries’ stock markets and government bond yields and interest rates.
First, let’s look at some of the valuations for the U.S. stock market showing why it is too expensive to invest in. The Top 10 PE10 and Bottom 10 PE10 charts show the 10-year average PE multiple for various countries. The U.S. has the third highest PE showing it is relatively expensive.
However, these PE multiples aren’t apples to apples because stable economies with liquid capital markets like the U.S. usually get higher multiples compared to the volatile countries which aren’t economically diversified such as Russia. India also might have a high PE because it’s a fast growing economy which has great demographics. The median age in India is 27.6 and only about 6% of the population is above 65. This means the peak of the population is in the workforce and is about to start accumulating wealth and buying goods (consumption peaks when a person is in his/her 40s).
One of the ways that you can adjust for various differences among countries is by looking at the country’s current PE and compare it to the country’s historical average. The chart below does just that as it shows the current forward PE multiple compared to the 10 year median PE. It’s tough to determine whether to use the forward or trailing PE because stocks are priced based on future earnings, but at the same time future estimates might not be hit. Trailing earnings are real. The chart shows that the U.S. is one of the most expensive markets compared to its past. The only way America isn’t expensive is if the earnings estimates are too low. Japan on the other hand is near its average PE. The only way you can say Japan is very expensive is if you think the earnings estimates are too optimistic.
Now let’s look at a reason why US stocks are cheap. Whether you think stocks are cheap or expensive, it’s imperative that you look at both sides of the coin. As you can see from the chart, the stock market is cheap when compared to bonds. This is the TINA (there is no alternative) argument. There is no alternative to invest in besides stocks. Another point is that low interest rates and high multiples encourage firms to borrow money to buyback stocks. Stock buybacks have been the backbone to this bull market. As long as the cost of debt is lower than the cost of equity for corporations, this trend will continue and stocks will have a bid.
In the past 8 years, asset prices have moved higher in large part due to quantitative easing. In October, the Federal Reserve announced that it will start quantitative tightening. All else being equal, this creates a potentially negative catalyst for equity valuations over time. Nothing happens overnight. Remember, the higher something costs, the greater your risks are. While monetary policy can influence markets and meaningfully impact them, it cannot do so indefinitely. As with nature, everything moves up and down, known as the business cycle. While it may not be appropriate to have all your holdings in equities, you must do due diligence for yourself to determine if stocks are expensive. Using relative valuations, as described in this article, can be one of the tools to help you with asset allocation decisions.
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