The financial markets are interesting things. Their direction is largely determined by emotion, yet everyone pretends they are based on cold, hard numbers. Past market behavior is easily quantified, so people feel like if they just study the numbers enough or use the right models, they’ll be able to figure out what will happen next.
We’re seeing that happen a lot lately with people saying the markets are “overvalued.” A number of people are suggesting that the Trump Rally, along with the longer-term bull market, has pushed prices beyond justification. Therefore, the markets must be on the verge of a downturn.
But there are some issues to consider here. Yes, stocks go up and down. And yes, Monday morning quarterbacks can always pick apart what happened in hindsight (though not always – markets can be weird, especially in the short term). But it’s dangerous to think that knowledge of the past gives us some ability to predict what will happen next (there’s even a fancy name for such a logical error: post-hoc fallacy).
There are two things that I want to look at here:
- Do high market valuations matter?
- What should you do about them?
Do High Market Valuations Matter?
Everyone is always talking about market valuations, especially the P/E (price to earnings) ratio. That must make it really important, right? It makes sense – the P/E ratio measures how much the market is willing to pay, on average, for a dollar of company earnings, so it can serve as a good, albeit general measure of the market’s exuberance. And once the markets get irrationally so, they must be poised for a drop.
This argument is appealing, but it has a fundamental issue. The markets constantly incorporate new information. If they operated like a board game, where everyone takes a turn and then you see what happens, then market valuations might be a useful predictor of future returns, but that’s not how it works. Valuations are never a surprise – everyone’s been watching them every step of the way. The financial markets are watched even more closely than celebrity gossip – TMZ has nothing on CNBC.
Everyone knew the valuations every step of the way, and, crucially, this information has been incorporated into current prices.
The markets (or rather, the individual traders that make up the various financial markets) understand that these valuations mean they are paying more and more for a company’s earnings. They understand that above-average market valuations have historically impacted stock returns. And yet, valuations have crept up.
So the market must consider these prices justified based on available information. After looking at everything out there, especially estimates of what will happen in the future, the market thinks the current prices are reasonable.
What the markets do next is based on what happens next. More precisely, stock prices will move based on how what happens next compares to what the markets assumed will happen next. Those expectations are crucial.
It’s not as simple as prices go up when good things happen. My favorite example of this occurred in 2013, when Apple reported record quarterly profits but its stock dropped by more than 10%.
The market expected Apple to have a really good quarter, but it turns out that those record profits weren’t record enough. The market expected Apple to do even better – and failing to meet those expectations meant that Apple’s stock dropped. Similarly, the market is pricing in the possibility that the current valuation metrics are telling us that the market is about to go down.
And even if you think the market’s taking its time pricing in the risk from high valuations, the time to do something about it was before Robert Shiller blogged about it for the NY Times. It’s pretty safe to assume the market will include that set of possibilities now.
Should You Do Anything About High Market Valuations?
To be very clear, making changes to your asset allocation based on valuation signals is market timing, which, as we’ve said before, is a brittle strategy. If you don’t get both the signal and timing right, you can hurt yourself pretty badly.
Regardless of how you choose to invest, market valuation metrics are incredibly noisy signals in the best of cases. Back when Shiller did his original work on a specific way to measure the P/E ratio called the CAPE ratio in the 80s, he found that P/E ratios explained about one-third of the variation in stock returns. Now, that’s a big amount, but it means that two-thirds of the returns were not explained by the P/E ratios. The other thing to consider is that he found those results before shining a massive spotlight on the importance of his P/E ratio.
So what does Shiller tell people to do? Quoting directly from his recent NYT piece, “Long-term investors shouldn’t be alarmed[.]” In other words, keep doing what you’re doing. Don’t make any changes to your asset allocation based on this information.
Most of the time, when academics find inefficiencies or “anomalies” with the market, their advice is pretty consistent: stay disciplined and focused on the long term. The market may not be perfect, but it’s like finding a slight hitch in Usain Bolt’s stride. It doesn’t mean you’ll be able to beat him.
They say this not because they don’t trust their work or their findings, but because the markets are incredibly noisy. We know that over the long term, stocks should have higher returns than bonds (otherwise why take on the risk from stocks), but in any given year we have no idea what’s going to happen. And as we tease out these more subtle relationships over longer time periods, the inherent randomness of the financial markets becomes more and more pronounced.
Really, the message we should be taking away is that we need to stay off the fear and greed cycle. The markets have had a couple very good months, but we shouldn’t assume that will continue. It may. It may not. We don’t know. And that’s why we stay focused on the long term and meeting your retirement goals.
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