How do you invest when markets are clearly overvalued?

US stocks are overvalued.

That’s what most sensible valuation measures say anyway. And this is something that investors need to be aware of. Because history shows that buying investments when they are expensive usually means you end up with poor returns.

That’s why you want to avoid buying an overvalued stock market.

Trouble is, the US has been overvalued on these same sensible measures for a very long time.

Now, the creator of one of the most important valuation measures – the cyclically-adjusted price/earnings ratio – is wondering if he’s been missing something.

Could stocks stay at these levels for a lot longer than anyone thinks? Or is this just yet another sign that we’re near the top of the market?

Our favourite valuation ratio

The cyclically-adjusted price/earnings ratio (Cape) is one of our favourite valuation measures here at MoneyWeek.

You’ve probably heard me go on about it plenty of times in the past. But just in case you’re not sure what it is, here’s the brief explanation.

A traditional price/earnings (p/e) ratio takes a share price (or the value of an entire market), and divides it by earnings per share. So it’s the price you’d pay, divided by the profits the underlying investment makes.

This gives you an idea of how expensive a market or stock is.  The higher the p/e, the more you are paying for a given pound or dollar of earnings. In other words, a high p/e is expensive and a low one is cheap, all else being equal.

This is all very well. But one of the many problems with the p/e ratio is that earnings tend to go up and down from year to year. Lots of companies work in boom and bust industries, for example.

If you look at the price of a housebuilding stock during a housing boom, the p/e is likely to be low compared to lots of other stocks, because earnings are unusually high. But that’s because earnings go up and down a lot in the building sector. You can’t always expect this year’s earnings to reflect next year’s – particularly if a housing bust is looming.

It’s a similar issue for mining stocks. The current p/e might look low. But a plunge in commodity prices might mean that next year’s earnings are a lot lower than this year’s.

How do you get a more reliable earnings figure? That’s where the Cape comes in. The ratio was created by professors Robert Shiller and John Campbell. It takes average earnings over a ten-year period, adjusted for inflation. A decade should be long enough to cover a full business cycle. And so it means you don’t get fooled by the bad years or the good years into thinking that a stock is cheap or expensive.

So that’s the Cape. It doesn’t tell you exactly when to buy or sell. But it does give you a decent long-term view of how expensive or cheap a market is. That matters. Because if you want to make money in the long run, you want to buy assets when they’re cheap, and sell or at least ease up on them when they’re expensive.

Does the Cape still work?

So, what does the Cape say today? The most widely-studied market is the US, which is handy, because it’s also the most important globally. And currently, the Cape reckons US stocks are very overvalued indeed.

As Shiller himself notes in The New York Times, the Cape in the US is now over 25. This level “has been surpassed since 1881 in only three previous periods: the years clustered around 1929, 1999 and 2007.” As Shiller adds – probably redundantly – “major market drops followed those peaks.”

That sounds really, really scary.

Trouble is, it’s been high for a long time. As Shiller notes: “It’s been relatively high – above 20 – for almost all the last 20 years, with the exception of 20 months, mostly in the recession of 2007-9, when prices tumbled and it fell as low as 13.32”.

And that’s got Shiller wondering whether there’s a good reason for this. He notes that bond prices are unusually high, and so interest rates are unusually low, which might help, as it makes the returns on stocks look attractive even when they’re relatively low by historic standards.

He also wonders if this is maybe because people are still so rattled about their future job security and incomes that they are keen to pile into investments to make up for it.

He’s not entirely convinced by either explanation. But it’s always worrying when the highest-profile bears start to question themselves. To be fair, Shiller isn’t a bear as such – he usually positions himself as an interested observer. But his theory garners a great deal of respect. So it’s worth paying attention to his doubts.

Is the Cape ‘broken’?

How to cope in overvalued markets

I don’t think so.

Some markets undoubtedly deserve to trade on a higher long-term Cape ratio than others. The US and the UK are politically stable and have long track records of rewarding investors in the long run. So it probably makes sense that investors will always be that bit more willing to pay up for those stock markets than they would for Russia or China, say.

But America’s over-valuation goes well beyond this.

I think there are two key things going on here. Firstly, investors have been thoroughly conditioned to have faith in central banks. If anything has skewed the Cape ratio over the past 20 years, I’d think that the unflagging, unquestioning support of central banks and politicians has got to be part of the answer. You might not like what central banks have done, but “Don’t fight the Fed” has unquestionably been a good investment strategy.

But I still don’t think that can prop up markets forever. So the second key point is a far more prosaic one. The fact is that valuations can be out of step with ‘reality’ for much longer than anyone – even the most patient investor – expects.

We should all understand this by now, but our brains keep fooling us. When something seems obvious – like current overvaluations – but the market doesn’t react, we start to assume that we must be wrong. We look for reasons why our valuation indicators have stopped working, rather than just understanding that sometimes these things take time.

In any case, another of Shiller’s measures points to reasons for caution. He’s also been measuring confidence in market valuations since 1989. In 2000, when the US Cape hit its highest level ever (44), confidence hit a record low. This year, confidence slid again, and is at its lowest level since 2000.

Is another correction in the making? I’m not willing to bet against it. How do you cope as an investor?

Don’t pull all your money out of the market and go to cash. Market timing is pointless and frustrating. But what I would suggest is to look at your asset allocation. Put less money in overvalued markets, and more money in undervalued markets. Also, consider drip-feeding money into markets – it means you automatically buy fewer shares the more expensive they get.

This is all pretty straightforward stuff. But if you want a more complete guide to it, my colleague Phil Oakley has more on how to do all of this in his Lifetime Wealth newsletter – you can learn more about it here.
• This article is taken from our free daily investment email, Money Morning. Sign up to Money Morning here.

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  • Longtermyieldman

    A possible explanation is that CAPE has become a less reliable indicator of company values over time. I can think of a couple of reasons why this might be so.

    First, the growth in share-based compensation has incentivised CEOs to ‘game’ earnings figures downward in bad times, using impairment charges and other non-cash items to drive down share prices when they would otherwise have fallen less heavily. A lot of this is still in CAPE valuations from the fall-out from the global financial crisis.

    Second, it makes no allowance for the state of company balance sheets. These tend to be quite heavily geared and asset-light at the end of bull runs when banks get loose with their lending criteria, sale-and-leaseback deals are commonplace and there has been a long run of acquisition activity. Currently many firms in the US and UK are substantially deleveraged.

    If CAPE were based on EV to EBITDA and excluded exceptionals, I suspect we would see that US stocks are fairly valued and UK ones somewhat below the long-run average.

  • George Bower

    Back in May Stepek wrote
    US Stocks are over valued but could go higher
    Top levels could be when the S&P hits 2250.
    Again, on 25th July, J Grantham ‘who has a track record that is
    difficult to ignore’ wrote almost exactly the same thing. He said ‘at least’ 2250.
    What has changed since these articles were written?

  • NVP

    I notice the word “reality” creeping into this discussion………..but sadly missing in most of the message ….

    if the market is different to ones own perception of “reality” ……then one needs to get aligned very quickly or suffer the consequences

    that’s what I teach my forex students


  • jimtaylor

    Are stocks overvalued?

    How do UK & US indices compare with pre-crash when adjusted for inflation?
    How much cash are companies storing up waiting to be invested in an upturn?
    How does GDP/head compare with pre-crash when adjusted for inflation?
    How much spare capacity do companies have, waiting for an EU recovery in particular?

    I don’t think we have seen anything of a Bull market, just a partial recovery at best.

  • NVP

    sorry – I missed a comment

    personally when playing stocks – i’m more a cashflow fan……….show me anything that generates solid and reliable (and hopefully increasing) cashflow without selling the silver ………..then i’m interested


  • norman

    “Now, the creator of one of the most important valuation measures – the cyclically-adjusted price/earnings ratio – is wondering if he’s been missing something.”

    Do you think maybe that the way it adjsuts for inflation, doesnt accomodate excessive devaluation by money printing?

    Then again I would think that would be relative, as it would affect both share price and earnings alike, but could it somehow affect the readings?

  • 4caster

    The unprecedented financial ingredient is artificially low interest rates, which have disrupted financial CYCLES and made “Cyclically Adjusted P/E ratios” unrepresentative. Even before the great recession, interest rates were kept too low because the benchmark was retail prices (consumer prices in the US). The result was excessive debt (consumer, public, corporate and international debt). But home-grown retail price inflation was hidden by imported deflation. Remember the £3 jeans from Asia? Commentators like Bill Bonner, John Mauldin, Stephen Roach, Gary Shilling, Roger Bootle and even Vince Cable were warning, as early as 2003, of an asset market crash if mortgage rates were to rise.
    Therefore asset prices have been kept too high for the whole of this century to date, because shares and property have been the only way to generate any worthwhile income.
    John Maynard Keynes wrote: “Markets can remain irrational a lot longer than you and I can remain solvent.” But interest rates will have to rise sooner or later. There may still be gains to be made on stock markets and in property. But very few people will recognise the warning signs in time to sell their assets before their value plunges.

  • norman

    Wow, very interesting point 4caster.

    But then I believe, on a very long teme scale, the market is at roughly the right price according to long terms trends. The graph I saw was on a logarithmic scale, due to the ever expanding debt based monetry system that we unfortunately have. So maybe it wont drop much in value, it will only be relative. Otherwise, when it all catches up, it would imply we are heading for a lower low than in 2009, but I cant see the wider market allowing that.