Yes, stocks can become overvalued

John Rekenthaler, vice president of research for Morningstar, questions whether investors should buy and blithely hold.
By Morningstar Analysts |  21-11-18 | 
 

When should investors reduce their exposure to equities because valuations are too high? And should investors always “stay the course”? Looking at stock market history, there are a few occasions when it would have been wise to shun shares, but still you would have needed to be lucky with your timing.

Mechanical rebalancing is one way for investors to cut their risk exposure. If stocks perform well, such that a portfolio that was initially 60% stock/40% bonds becomes 70/30, then it's logical to rebalance to the original allocation. After all, nothing changed from the initial decision.

Rebalancing, however, is more easily said than done, because while maintaining a consistent asset allocation makes economic sense, it's not much fun to implement. Selling winners feels good if stocks then decline, but if they do not, the opportunity cost can sting. Worse yet is the opposite situation when investors buy equities when the headlines are urging otherwise, only to see stocks fall further.

Thus, rebalancing is best done automatically: establish a trading rule; follow its instructions devoutly; and suffer no regret if the transaction turns out badly.

Models don't reflect real world

Unfortunately, I do not see how mechanical processes can guide investment strategies that are based on stock market valuations. Those who have tried – most famously by using the Shiller CAPE P/E Ratio, which examines stocks' cyclically adjusted price/earnings ratios – have failed. Such measures work well in hindsight, but they have not been useful predictors.

The discrepancy occurs because things change. Implicit in every market indicator is the concept that the past repeats itself. The stock market's fluctuations – and the breathless stories that accompany those gyrations – create a false impression. They suggest that this time is different, when in fact it is not. The average, unbeknownst to the forecaster, has moved.

It may be that future conditions remain similar to those of the past, in which case the newly released indicator will likely prove valuable. But often, that is not so. For example, owing to a low inflation rate, the lengthening of the economic cycle, and record corporate profit margins, the price ratios for US stocks have been higher during the past 25 years than they were before. That has played havoc with stock market price indicators, the Shiller CAPE Ratio included.

Lessons from history

Which leaves those wishing to avoid an overpriced equities market depending on judgment. For 20 years following the conclusion of World War II, there was no judgment to be applied. Remaining in equities was the correct decision.

Then came 15 terrible years, through the mid-1980s, when the stocks were devastated by inflation. For that stretch, investors would indeed have done well to avoid equities. However, making that choice involved understanding the economy, not judging the level of equity valuations. It wasn't that stock prices were particularly steep. It was instead that inflation spiked far higher than it had been, and also far higher than it would become.

Since the early 1980s, stocks have crashed three times.

Two of those occasions, I believe, were almost impossible to anticipate. Black Monday in 1987 came out of nowhere. The 2008 financial crisis, on the other hand, happened for well-documented economic reasons. Across the globe, banks collapsed and housing markets sunk. No stock market indicator could have anticipated that.

The one occasion in which judgment served was during the dotcom boom, when technology stocks posted valuations that still exceed all subsequent levels. Sentiment was equally overheated. That truly was a time to slash one's stock market exposure. Even then, though, the timing needed to be right. Those who sold equities in 1996 fared worse than those who stayed the course and held through the worst of the downturn.

Sometimes stocks do cost too much. But recognizing when that situation arises, and profiting from the knowledge, is a tough task.

This post initially appeared on Morningstar.ca 

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