The Inexact Science of Market Valuation

By Jack Forehand (@practicalquant) —  

When it comes to market valuation, investors love certainty. They want to hear definitively that the market is cheap, or the market is expensive, and that they can use that information to predict where it is headed in the short-term. As a result, strategists that make these type of market calls (particularly the ones who do so on the negative side), can generate significant headlines and attention for themselves.

None of this does anything to serve investors, though. These simple headline grabbing takes on market valuation take an issue that can be very nuanced and try to make it simple, and as a result, the conclusions that are reached are almost always flawed.

Trying to use the market’s valuation to predict short-term outcomes misses two important points that should govern any analysis of market valuation.

  1. The valuation of the market is often very different depending on the metrics you use
  2. Market valuation is not useful is predicting short-term outcomes


Let’s tackle these one at a time.

The Arbitrary Nature of Market Valuation

There is a popular belief that the current market is very expensive. Look at the chart below, which shows the median price/sales of all stocks in our database since 2005.

Even after the recent pullback, we are still in the 88th percentile (stocks have only been more expensive 12% of the time during the period). And this has been a period of elevated valuations relative to the long-term, so if you looked at a longer-term chart, you would see even greater overvaluation.

It seems reasonable to conclude based on this data that the market is very expensive.

But the price/sales ratio is only one of many ways to look at market valuation. The below chart looks at valuation using trailing twelve-month earnings.

Now it looks like stocks are actually fairly valued, with a PE in the middle of the range.

Why the difference? There are two main reasons. First, profit margins have been rising for some time now, which makes the market cheaper based on earnings than it is on sales. Second, the tax cut that went into effect this year has boosted profits substantially, but not sales. This leads to a cheaper market based on earnings than sales.

So which one is right?

The simple answer is neither. If you believe that elevated profit margins are here to stay and the tax cut will be permanent, then you will think the second chart is more accurate. If you think the opposite, then the first chart will be more representative of the true market valuation in your opinion. Either way, there is no right or wrong answer, just different ways of looking at the same problem that lead to completely different conclusions.

To complicate things further, let’s look at the most often used tool for market valuation, the CAPE ratio. The CAPE is just a PE ratio that uses the average of the most recent ten year’s earnings instead of the most recent year. This tends to paint a more normalized picture of valuation at different stages of the economic cycle.

The CAPE presents a valuation that is in between the other two. It shows a slightly overvalued market.

The CAPE is also a good way to look at how arbitrary market valuation can be. The oldest year currently included in the CAPE is 2008, which also happens to be the year of a significant financial crisis. As a result, earnings that year were down substantially. Once 2018 earnings are reported, 2008 will be dropped an replaced with that year, and that alone will drop the CAPE by 2-3 points. Since the Financial Crisis also brought down 2009 earnings significantly, when that year is removed the ratio will likely drop another 2-3 points. This is all assuming the market stays where it is now.

Whether you believe the current CAPE is artificially high due to those outlier earnings or not, that 4-5 point drop in the CAPE will have nothing to do with the future value of earnings, which is what stocks ultimately are valued on. The market won’t be worth more or less on the day it happens. But it goes to show how arbitrary stock market valuation can be.

Does All of this Matter Anyway?

Analyzing each of the three charts above can lead to three different conclusions about the current market valuation. The more important question, though, is even if you could figure out which one is right, what could you do to profit from that information?

That is where the whole process breaks down, because even if you know whether the market is overvalued, undervalued, or fairly valued, that information isn’t actionable in the short-term. The chart below from Vanguard shows why. It looks at a variety of market valuation metrics and how well they explain future stock returns.

As you can see, none of the valuation metrics examined did a meaningful job of explaining one year forward stock returns. Put another way, the market valuation is essentially meaningless in predicting what the market will do in the next year. It isn’t in the chart, but the same is true of the next three years. Periods of overvaluation and undervaluation can persist for extended periods of time, and those who try to use valuation to time the market are very likely to be disappointed in the results.

And that is before we take the effect of emotions, which would most likely make the process even worse, into account. To illustrate why, consider what would have happened if you had tried to time the “overvalued” stock market of 1997 and moved to cash based on valuation. The market was very expensive at that point by almost all metrics, but in the next 2-3 years, it got a lot more overvalued. You would have eventually been proven right when the 2000 Bear Market hit, but you would have had to sit through years of watching everyone around you make substantial gains, while you did not, to get there. Almost no one can do that without eventually capitulating and buying back into the market, and that capitulation usually occurs near the market peak, leading you to lose on both sides of the equation.

Valuations: More Interesting Then Useful

None of this is to say that you should never look at market valuations. I know I look at them fairly regularly to see where we are in the context of history and some of them like the CAPE are also useful as a way to estimate future long-term returns. But it is important when you look at valuation metrics to understand that they can often disagree with each other, which makes figuring out the correct one to use difficult. Even if you can get past that step, they offer no value in predicting the market over the periods of time you are likely using to make decisions about your portfolio. So next time you see valuations used to predict where the market is headed in the short-term, take it with a grain of salt. Despite the confidence the person who is doing it is likely showing, the data doesn’t back them up.

Photo: Copyright: feelart / 123RF Stock Photo


Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.