US stocks may be more overvalued than they’ve ever been before

US stocks are overvalued.

It’s been like this for a long time. And in fact, I’d argue that it’s an entirely uncontroversial thing to say.

Any objective observer would admit that by most – if not all – traditional measures of valuation, US stocks are expensive.

But a new paper from value investor GMO gives quite an eye-opening view of just how expensive they really are.

US stocks are even more overvalued than you think

Behavioural economist James Montier and his colleague, Matt Kadnar, over at US value investors GMO, have just put out a very striking paper looking at how overvalued US stocks are right now.

The Shiller price/earnings ratio (or Cape) is a well-known measure of valuation. It averages earnings out over a ten-year period in order to capture the effect of a whole business cycle (so you’re not being fooled by unusually high or low earnings). This measure currently suggests that the market has only previously been this overvalued in 1929 and in 1999.

Some try to criticise the Cape by arguing that the inclusion of 2008 – the financial crisis years – pulls down the average. So Montier and Kadnar looked at an alternative to Cape, the Hussman p/e. This excludes the low-earning years in the average. What does it show?

Well, it’s even worse. On the Hussman p/e, the market is more expensive than in 1929. Only 1999 surpasses it.

Montier and Kadnar point out that, unless you believe that investors are now permanently willing to pay an awful lot more for equities than they were in the past, or that sustainable profit margins are permanently a lot higher than they were in the past, then stocks are undeniably very overvalued.

It’s the same if you look at the level of individual stocks. On a price/sales basis, “the average US stock has never been more expensive than it is currently, even at the height of the insanity” of the tech bubble.

Finally, say Montier and Kadnar, if you go hunting for “deep value” stocks – based on classic Ben Graham criteria – then you’re in for a shock. Using this measure to screen for stocks in late-2008 would have shown that around 5% of the US market could be categorised as “deep value”, while up to 20% of Japanese stocks were.

Now about 5% of Japanese stocks are deep value; and just 2% of UK and European stocks are. As for the US? 0%.“Not one single solitary stock can be called deep value.”

OK, so the market’s expensive. What’s the answer? GMO’s solution currently seems to be to invest in emerging markets. However, it’s very much the case that this is the best of a bad bunch.

“The cruel reality of today’s investment opportunity set is that we believe there are no good choices from an absolute viewpoint – that is, everything is expensive. You are reduced to trying to pick the least potent poison.”

They’re only projecting a return of 2.9% a year (in “real” terms, so after inflation) over the next seven years for emerging market stocks. (This forecast is based on the idea that both valuations and profit margins “revert to the mean” over time.)

But that’s a lot better than the negative 3.9% real annual return they expect from US stocks. That’s one of the biggest gaps in expected relative returns going back several decades.

A common misconception about bubble markets

The big question, of course, is what makes these bubbles pop? I’ve been thinking about that a lot recently. The market has only ever been this over-priced prior to the 1929 and 2000 crashes. So what can they tell us?

One key point is that there are a lot of misconceptions about bubbles. One is the idea that everyone is oblivious to the level of over-valuation. That’s simply not true.

Investors are taking a certain amount of comfort today from the perceived absence of exuberance in the market. The idea that this is “the most-hated bull market ever” has gained a lot of currency.

But quite aside from the difficulty of measuring this notion, there’s never been a bull market without its share of detractors. In 1929, despite all the fun of the Roaring ‘20s, there were plenty of sceptics. As Edward Chancellor notes in his classic, Devil Take The Hindmost, back then “it was commonly said that the market was ‘discounting not only the future, but the hereafter’.”

In 2000 too, many journalists were questioning the wisdom of the bubble. Most of the sceptics were expressing exhaustion by the end of the boom – bears throwing in the towel is a common phenomenon at the end of a bubble – but there were plenty of them.

Equally, the people who invest in stocks are not oblivious either. The latest Merrill Lynch Bank of America fund manager survey shows that more fund managers think that global equities are overvalued than at any point since the tech bubble.

To be clear, fund managers will stay invested. They basically have to. That’s their job. That’s why their actions – the way that they invest their money – can often be seen as contrarian indicators.

But they understand that they are walking a tightrope. They have a pretty keen idea of when markets are expensive and when they’re not. And right now they agree that they’re expensive. It’s just that they’d rather be invested in an expensive market, than not be invested in a market that’s still going up.

So what’s keeping stocks afloat? GMO founder Jeremy Grantham – respected bubble-spotter and market historian – is increasingly convinced that this expense can last for some time. For as long as interest rates are low, basically.

That makes some sense. But what I wonder is if there comes a point where markets simply collapse under the weight of their own contradictions. The other key point about 2000 and 1929 is that there’s no obvious trigger for either collapse. In both cases, it’s almost as though investors woke up one morning and started paying attention to the bearish arguments.

That could happen regardless of what the Federal Reserve or even Donald Trump decide to do. I’d suggest playing it safe, and as I’ve said before, keeping a higher allocation to cash than normal. Remember that the big benefit you have over a fund manager is that you don’t have to be invested to the hilt at all times – you may suffer from the fear of missing out, but at least you won’t get fired for doing so.


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