- Valuing the market: Are shares cheap?
- Valuing the market by P/E ratio
- The cyclically-adjusted P/E ratio (PE10 or Shiller PE)
- Valuing the market by earnings yield
- The stock market capitalisation to GNP (or GDP) ratio
- Why a higher P/E ratio for the market could lead to higher returns
- Proof that most methods of making stock market predictions don’t work
Hearing that I’m one of those oddballs who is still investing in the stock market, people ask me things like “Are shares cheap?” or “Is it a good time to put money into an ISA?”1
Invariably I waffle in reply that regularly saving into a cheap diversified portfolio over the long-term is a good practice that sidesteps such concerns.
But if the questioner is more sophisticated – or more persistent – I may venture a view that a particular market looks cheap or expensive, in my opinion.
‘Sophisticated’ here means experienced enough to have heard such views hundreds of times before – and so hopefully formed the opinion that they’re not worth very much, especially in the short-term!
(The most sophisticated investors are arguably those who ignore all this kerfuffle due to the evidence that it probably won’t give them any edge, and so invest purely passively instead).
However one fellow – a Monevator reader, to boot – surprised me the other day when he asked me what we actually mean when we say ‘shares look cheap’?
A very good question.
Over this series of posts, I’ll outline some of the ways you might hear people arguing that the stock market is at bargain levels, grossly expensive, or something in between.
I’m not going to consider the present state of the market. I want this series to be more of a reference guide than a one-off market call. You can then use the methods described in whatever market conditions you face in the future.
You can guess evaluate along with the rest of us!
Price is not the answer
Firstly, let’s look at what doesn’t work, at least for private investors like us. And that’s technical measures based on prices.
To my knowledge nobody can consistently predict and profit from short-term stock market moves. If you hear some pundit saying for example that the market has advanced “too fast” and so we “are due for a pullback next week” ignore them. They don’t know anything you don’t know. (On this evidence they may know a lot less).
I don’t personally believe that stock markets are totally efficient. There’s evidence that momentum exists in prices, for example.
But that doesn’t mean I think it’s easy to profit from short-term gyrations in the overall market. Quite the opposite!
Investing in shares is not unique in this respect.
Imagine you’re an expert in antique furniture. If I put a tatty old chest of drawers up for sale in the newspaper small ads for £20 and you realise from my description that it’s a Georgian antique, you’re well placed to make a profit.
If I auction it, however, the chances are others will spot its value, and bid against you. This activity itself can draw more expert traders to the fray. I may be ignorant about antiques, but this process means my lot should still sell for around the going rate in a public market.
Ah, but what is that going rate?
As an expert in classic furniture, you will have a view. You might exit the auction early because “prices look toppy”. Alternatively, you might laugh maniacally as you strap the drawers onto your roof racks, muttering to anyone in earshot that: “the market is temporarily depressed, but one day true value will reassert itself”.
You sound very knowing. But a year or two later, you may be saying the same thing as my drawers gather dust in the corner of your shop.
Fashions come and go. Your expertise in old furniture was enough to tell you that my chest of drawers was Georgian and you knew such items had traded at a high price in the past. But it didn’t give you any omnipotent clairvoyance about whether and when other buyers would pay what you consider a fair price for Georgian drawers in the future.
The odds may be on your side. Your knowledge of both antiques and fashion trends – and even the mood of your fellow dealers – all help.
But there’s no certainty.
Prices are adrift without an anchor
This is all very familiar to investors in shares.
In the years immediately after the dotcom bubble burst, you’d often hear pundits urge others into the market on the grounds that the FTSE 100 was 10% or 20% or 30% down from its high.
But this simple 10%-off type answer to the question “are shares cheap?” proved a poor guide to the future level of the index. Twelve years on and the FTSE 100 remains below its high of late 1999.
Some markets might never return to what you once considered a reasonable price (as I have found to my cost with London house prices). Many people are late to buy into recovering stock markets because they become anchored to a low price point, and forgo gains while waiting for a retrenchment that never comes.
They get scared because the market has risen 20%, but who is to say it was fairly priced then? Perhaps it was excessively cheap?
Going on pure prices/levels isn’t much use, then, whether you’re buying a new Art Deco sideboard or wondering whether now’s the time to put your inheritance into a UK tracker. If the FTSE 100 was once 6,500 and it’s now 5,500, it’s not at all evident from these numbers whether the old level was too high or the new level too low, let alone where prices will be in the next year.
Head too far down this road and before you know it you’re a chartist looking for triple candlesticks up your golden Uranus as you try to simplify an inconceivably complicated summation of opinions about every company in the index.
Price versus value
Don’t get me wrong – every investor looks at stock market graphs, even if they don’t admit to it. Even passive investors take solace from graphs showing the UK stock market climbing remorselessly over a hundred years or more.
I am not immune to price anchoring and other behavioural quirks, either. But personally I try to fight the daily impulse to consider shares cheap or expensive based on the absolute level of the index.
Instead, if you want to reach an opinion about whether the market looks cheap or expensive (and remember, that’s very much optional to a good investing plan) I believe you need to try to value it against something more fundamental.
And here’s a big difference between investing in antiques and buying into the stock market – one that’s often missed by newcomers to shares.
If I buy a FTSE 100 tracker, then I am buying a slice of all the future earnings of the FTSE 100, which I hope to be paid through a regular dividend and/or a rising price due to companies reinvesting their profits. Both earnings and dividends tend to rise over the long-term, not least due to inflation, so if I can wait long enough I’ll likely be rewarded.
In contrast, my Georgian chest of drawers either goes up in price, or it goes down.
Okay, technically speaking, my drawers provide a functional utility that has a value that ownership confers. You can store underpants in them, for example. More subtly, you can also show off your wealth by putting them in your living room (my drawers, not my underpants, though I can see the confusion).
If you didn’t buy my antique drawers, you might have to go to IKEA to get storage for your pants, and frame and display a bank statement to show off your wealth.
However I think it’s fair to say most of the premium in an antique over a sturdy knock-off is in the expectation of the value to be realised through a future bid2.
Such an expectation isn’t groundless – real assets tend to appreciate ahead of inflation over time, which is why investing in quality furniture, houses, stamps and even art can help preserve your wealth. But the utility value you’re gaining from it is a lot more vague than the dividend yield you get on a basket of shares.
And however long you wait, I don’t think you’ll ever get what you paid for your 1970s avocado bathroom suite.
Ways to value the market
In short, we need to relate the level of the market to some other value – such as those company earnings or the dividend yield – in order to see if it’s reasonably priced or not.
I’m not the first to reach this conclusion, unsurprisingly. Over the years, many different rules-of-thumb have been devised to try to decide whether shares are cheap or expensive.
The rest of this series will highlight some of the more popular ways you may hear being used to value the market according to these so-called fundamentals.
None of these methods gives you a silver bullet solution to timing a market.
Far from it!
Hedge funds crunch tens of thousands of variables and still they run off a cliff in a year like 2008. To expect a simple ratio to give you a solution to the age-old quest for the holy grail of market timing is bonkers.
That said, I don’t think it’s folly for someone to decide to take an overall view on whether shares look good value, and to tweak (not wantonly trade) their allocations accordingly.
The academic evidence is that most investors would historically have done better to stick to fixed asset allocations and rebalancing as opposed to attempting market timing. But for those of us who do dabble with the dark side, these valuation methods may collectively cast a little light and help us to do better.
At the very least, after reading this series you’ll be able to decode even more City-speak when you hear it!
Comments on this entry are closed.
The Accumulator is away.
(As they say in The Sunday Times. He’s back next week!)
Investor , according to the gold bugs shares are about to become abnormally cheap due to a possible currency collapse , i asked at hargreaves out of interest what happens during such an event :
With regards to your enquiry concerning the effect of a currency collapse on stock prices, providing the stock is still considered as having the same value as before the collapse of a currency, and all other things being equal, then the fall in value of the currency would simply mean that the price of the stock would rise comparatively in relation to that currency. Should a currency be valued at zero, then another currency would have to take its place as a measurement of value.
This question is extremely theoretical, however, as any significant fall in the value of any major currency would likely have a huge effect not only on stockmarkets, but also the values of other major currencies around the world.
Investor , do you think the gold enthusiasts are simply scaremongering , or do you think there is any validity to it , thanks.
Great post Monevator! “If you hear some pundit saying for example that the market has advanced “too fast” and so we “are due for a pullback next week” ignore them. ” Yes! I love it. Looking forward to more…
@DavyJones If the currency completely collapsed it would have a huge impact on shareprices as the economic disruption that followed would lead to a dramatic fall in the future value of dividends. I think the German stock exchange was pretty much wiped out in the 1930s.
Outside of a meltdown I think unexpected inflation would be bad news for bondsholder and those with cash. But within normal limits it might benefit shareholders in indebted companies by transferring money from indebted companies(and governments) from bondholders/giltholders. I guess the conspiracy theorist believe that as big debtors governments might want a bit of inflation. The only problem is that in order for this to work it has to be unexpected inflation, and as the government needs to roll over its debt quite frequently I am not sure it could be done.
Gold never pays any dividends which worries me a little bit. I know Gordon Brown was criticised for selling off the gold pile, but it seems to me it might have been a good idea to have sold the gold off after we came off the Gold Standard and invested in a nice diversified bond and worldwide equities fund.
@TheInvestor – another quite brilliant post, I don’t know how you keep knocking them out.
@Davy Jones – gold is a way of hedging against a currency collapse, but if it doesn’t happen and gold goes out of fashion what’s its intrinsic value? In the case of a currency collapse I would favour exportable items although you shouldn’t just run with one asset class anyway so there’s room for both so long as you know the potential risks and benefits.
With the currency collapse your domestic market will collapse, but if a company can export then they still do okay-ish selling abroad using the favourable exchange rate. In such a situation you’ll find domestic services except those that are exportable cheap so if you own part of an exporter you get more coming in than you spend on say getting a haircut. Food, however, would become one of the key items that would rise in price so that’s something to consider. Alternatively, invest in assets in foreign currencies if you’re very worried. Gold could form a component in a portfolio so long as you had other assets that could cover it if the bet went against you.
If a country runs with a budget deficit you really expect currency devaluation at some point. If a country was a person and they kept spending you’d expect the quality of their credit to decline right (a) because of so much debt and (b) because they don’t seem trustworthy? I see little reason why the same can’t apply to a country.
Warren Buffett’s 2012 letter to investors is eloquent on this and will repay a reread. Here is an extract:
“The second major category of investments involves assets that will never produce anything, but that are purchased in the buyer’s hope that someone else – who also knows that the assets will be forever unproductive – will pay more for them in the future. Tulips, of all things, briefly became a favorite of such buyers in the 17th century.
This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce – it will remain lifeless forever – but rather by the belief that others will desire it even more avidly in the future.
The major asset in this category is gold, currently a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful). Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end.
What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis.
As “bandwagon” investors join any party, they create their own truth – for a while.”
1. Thanks, as ever, for another great post.
2. One observation, though. You say: “But this simple 10%-off type answer to the question “are shares cheap?” proved a poor guide to future returns. Twelve years on and the FTSE 100 index remains below its high of late 1999.”
3. Isn’t this a misrepresentation of “future returns”? We could have been reinvesting dividends all that time in market. So, we’re not solely dependent on the price return.
4. Are you an active fund manager? Ha ha. This, as you know, is a standard trick of some of them: plotting the total return of their fund (dividends reinvested) against a price index (i.e. without dividends).
5. PS: “The Accumulator is away.” With the fairies? I’ll see him there, then.
Thanks all for the comments.
@Davy Jones — Paul and the other readers have given you some good food for thought there. There are several other points I’d briefly make.
Firstly, gold may indeed be good at anticipating / hedging currency collapse and/or inflation, but you have to (try to — and I don’t know a good way) assess how much of that is in the price already? It’s already run up roughly 700% from its turn of century lows in Sterling terms.
I agree with Hargreaves Lansdown. Shares in companies are a real asset that can respond to changes in currencies (/inflation) — if you have to push a wheelbarrow of devalued notes to your local Tesco to buy a loaf of bread, then Tesco theoretically reports an extra wheelbarrow of sales in that devalued currency. That said, some versions of currency ‘collapse’ would have an absolutely enormous disruptive impact, and it’d be foolish to think the market would sail through.
But what is ‘collapse’? The UK left the ERM peg for instance in the early 1990s, the pound devalued, and stock markets rose.
You may find these two articles of interest with respect to the more moderate ‘excessively inflationary’ outcome:
http://monevator.com/fear-inflation/
http://monevator.com/stop-inflation/
I’m impressed with HL’s customer service, btw!
@Kurt @Rob – Thanks for the kind words.
@Alex — Cheers, and fair point, I have adjusted the copy accordingly. Despite winning “Most Caveat-Happy Blogger of the Year” for three years running, the odd inexact exactitude does get through. 😉
@Dave
> I think the German stock exchange was pretty much wiped out in the 1930s.
According to Adam Fergusson’s book When Money Dies, German stocks plunged to about a hundredth of their value relative to other things before largely recovering.
Sounds like a great buying opportunity, but think about what it means. If you start off with £1m in the stock market, you have to be prepared to let that fall to £10k in terms of stuff you can buy. And still have the guts to hold those stocks, indeed perhaps TI will be buying, though what with? He’d have to be selling real stuff, because his cash savings would have been destroyed in a fall of twelve orders of magnitude. So the stock market isnt a bad place to be in a hyperinflation, provided you can survive seven years in a barter economy for your basic needs. It’s like a lot of things to do with stocks – the theory of it is easy enough, it’s the execution of the theory that is hard.
Food, property, energy – these are the things that retain value when money dies. And property means productive land, not your BTL portfolio 😉
I appreciate the feedback Investor , Dave , Rob , Paul , ermine.
The gold buyers must have bought there gold in crytal ball shapes because they come across as knowing the future , yet with so few ppl owning gold .. no wonder as new entrants arrive it drives the price.
I know you shouldn’t chose any one specific asset class , but historically .. have smaller company stocks beaten value investing on a relative basis does anyone know.
An increasing dividend income could be more useful in retirement or in lean periods than fixed income instruments over decades , although one way to perhaps mitigate inflation would be to move to another country where your money buys more , having visited asia recently i can testify that clothes , food , transportation & to a lesser extent rent prices can be upto 4 times less than here in the UK.
I should have put in the link to Buffett’s 2012 letter. The section on pages 17, 18 and 19 is well worth the read.
http://www.berkshirehathaway.com/letters/2011ltr.pdf
The market does not seem to be pricing in much inflation risk in gilts. The yield on long dated gilts is low, I am not sure anyone would buy them if they really imagined we face run away inflation.
I suspect the reason Gold Bugs are so keen on gold is due to psychological factors. Bubbles are often caused by
1. Confirmation Bias- the tendency of people to favour information that confirms their biases.
2. Herding Behaviour – tendency to follow a crowd.
3. Greed/fear – leading to a tendency to overreact.
I think another factor is a sort of positive feedback whereby when people telling another person how to act helps to convince them their initial viewpoint is correct. Rather like the way teaching someone is often the best way of learning.
Finally a person might see themselves as a “Gold Investor” and once you have adopted an identity it is quite hard to start acting in another way as you have made a big emotional buy in.
So someone might start out believing that a bit of gold is a good thing sometimes. Then they make big gains, start to hang around forums on the net where other people are investing gold(and making money out of it), they start to see themselves as the kind of person who invests in gold. Then they go outside their normal forums with their charts showing gold increases since 1990 or 2000 and try to convince everyone else they are correct.
Fortunately I am immune to these psychological biases* and wonder about an asset that little in the way of capital appreciation and no income.
*Wishful thinking…