Investing

The Role of Valuation

Many financial pundits have expressed concerns over what they deem to be elevated valuation levels for the stock market over the past several years. Relative to history, stock valuations are certainly elevated.

Before proceeding, I want to make sure everyone knows what I mean by valuation. First, valuation is not price although the two are related. Valuation is often times measured by comparing price to another metric such as income or earnings. The comparison is usually expressed as a ratio of the price to the other metric. This ratio expresses the valuation level at a given point in time. It can be compared to historical ratios such as the long-term average to provide a frame of reference for today’s valuation level. If today’s valuation level is above the average some might consider it to be expensive while if it’s below it might be considered to be cheap. Generally speaking, nobody gets excited unless the current valuation level is well above or well below the historical average.

As an example, we’re all familiar with the housing market and have likely looked at housing prices before. How can we know if housing prices or valuations are expensive or not. Most of us look at the sticker price and conclude whether a house is expensive, cheap or fairly priced. While a house price may be high for any of us individually, it doesn’t mean the valuation is expensive. One possible valuation lens through which we can view housing prices today is to compare them to household incomes for a given geography. If the ratio of the median housing price for a given market today relative to the median household income is well above or below the historical average we may conclude housing valuations for the given market are expensive or cheap. Another valuation lens we can use is looking at the price per square foot of an individual home. We obtain this metric by dividing the price by the number of square feet of the home. We can compare the price per square foot for a given home to the price per square foot of other comparable homes (size, location, # of beds, # of baths, etc…) to determine if a specific home appears expensive, cheap or fairly valued.

When examining individual stocks and the stock market, we perform the same types of analysis. We may look at the valuation level of the stock market overall, which would be similar to looking at housing valuations for a given market. Or we may look at the valuation level of an individual stock which would be similar to looking at an individual home. In the case of stocks, we often look at the price of the overall market or an individual stock and compare it to earnings. There are many valuation lens through which to view the stock market and individual stocks. For the sake of simplicity, we’re going to use price-to-earnings.

What Do They Mean?

When financial pundits declare the stock market is expensive, they simply mean the price to earnings ratio of the overall stock market is well above the historical average and in today’s case is near all-time highs. In the chart below we compare the value of the stock market as captured by the Wilshire 5000 Index and compare it to US gross domestic profit, which is effectively our nation’s income. For those that are interested, this is one of Warren Buffet’s favorite valuation metrics.

As of the most recent final reading of GDP (4Q18), the stock market is near all-time highs relative to our country’s GDP. Additionally, you can see the ratio is well above the long-term average ratio. So when you hear someone state the market is expensive today or valuation levels are high, this is what they mean. Remember, they’re not referring to the price in isolation. They’re referring to the price relative to another metric such as income or earnings and how that ratio compares to historical levels.

Does It Matter?

Many look at valuation levels as a harbinger of stock market doom. High valuation levels certainly don’t make us feel warm and fuzzy all over but they aren’t the fail proof signal that a market crash is imminent. What valuations do tell us is whether something is expensive, cheap or fairly valued relative to some historical frame of reference such as a long-term average. Valuations can also help us to establish realistic expectations for future returns. For example, if we buy a stock or the stock market at an expensive level, there is a greater likelihood our returns will be lower in the future versus if we were to buy at a cheap level. Keep in mind there are numerous variables that contribute to the eventual outcome such as your time horizon, which is the time period for which you hold an investment.

With valuations at elevated levels today, expected future returns over the next 10 years are likely to be lower than they’ve been over the previous 10 years. The starting valuation level 10 years ago, was the lowest level in nearly 20 years at the time so it represented an attractive entry point for an investor to buy stocks. It was attractive because the market was cheap relative to the past 20 years of history, which meant the odds were that future returns would be higher than they might otherwise have been. Needless to say, it’s been a good 10 years. Looking forward, the odds are returns won’t be as favorable as we’ve recently experienced. Granted, there may be months or even years with nice returns but over a longer time horizon they may not be as nice.

What To Do Now

Nothing. Just kidding…kind of. If you’re already invested then don’t do anything. Market timing is incredibly difficult and you likely won’t succeed. If you’re looking to invest, then you need to realistically consider what your time horizon is. The longer it is the less you have to worry about. The shorter it is the more cautious you need to be. You should consult with your financial advisor to develop an appropriate strategy that is in your individual best interest.

Remember, it’s better to buy low and sell high than to buy high and sell low. There’s nothing that says you can’t buy high. You just better have a long time horizon.