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Weekend reading: My own (dubiously useful) view on current stock market valuations

Weekend reading

Plus good reads from around the Web.

A recent investor event I attended gave the usual insights into the average private investor’s mindset.

In 2011 I went to a monthly investing meet-up in a pub, where the talk was all of gold and oil miners. Literally nobody wanted to talk about anything else. It was one of the biggest contrarian signals I’ve ever encountered.

This time virtually everyone was debating how to prepare for the imminent stock market crash.

I’m not exaggerating – about the only people who weren’t preparing for a crash were those who believed such preparation was futile. On balance they still expected a crash, but they had a sort of passively-active mindset that steered them towards investing through the seemingly inevitable meltdown.

Is this just as big a contrarian signal as the one I saw in 2011? Does this universal pessimism mean we can be optimistic about future returns?

I’m not sure.

American splendour

While a five-year old and largely hated and ignored bull market doesn’t in itself point to an imminent plunge, higher share prices do mean inferior value and so lower returns in the future.

That’s just the way the maths works.

The US market still looks to me by far the most expensive. I’m very underweight there, and what I do own tends to be in the ‘beaten up’ category.

The always thought-provoking Meb Faber highlighted the relative expensiveness of US stocks this week in an article on home bias:

The U.S. is actually above the upper end of the range for expensive countries. […]

The U.S. was cheap relative to the rest of the world in the early 1980s, which also happened to be the start of the long bull market. [Whereas] the late 1990s saw the U.S. near the top of the range, which preceded the bear market that began in 2000.

Will the current overvaluation signal another bear or perhaps a time to shift more assets to foreign markets?

There was a similar point made by another US blog, A Wealth of Common Sense, which pointed out the average investor is greedy and fearful at exactly the wrong times:

A recent study from Harvard showed that in February of 2009 (during the crash), investors expected annual returns of only 3.9% a year going forward.

But in January of 2000 (during the tech bubble), expectations were for 14.3% annual returns.

Of course 2009 was a terrific buying opportunity while 2000 was not the time to be upping your expectations for future gains.

Perhaps those skittish investors I met are right to be cautious then – at least if they’re thinking of the US market?

Or are they set to be confounded again by this huge long melt-up that nobody has ever really celebrated?

To bail or not to bail

While I agree the US seems to be the most over-valued stock market index, that doesn’t mean it’s a reason to bail out of equities altogether.

Indeed The Wealth of Common Sense blogger seems to fall into this trap himself.

Wisely admitting how difficult market timing is – and addressing a US audience – he suggests that only the following three classes of investor should sell US stocks here:

1) Investors that have spending needs within the next few years (this has always been the case).

2) Investors that have seen their asset allocation to stocks drift much higher than their target portfolio weight (this has always been the case).

3) Investors that don’t have the willingness or ability to withstand periodic losses in exchange for longer-term gains (this has always been the case).

This is very solid advice, but I would suggest there’s also some home bias creeping in here, of the kind Meb Faber writes about.

That’s because there’s a fourth class of investor who might sell – an investor who is prepared to reduce his or her US exposure in favour of apparently cheaper overseas markets.

Cheap and expensive countries

Where might they be? The Meb Faber article has some pointers, and so did the Telegraph this week.

Its analysis looked at cyclically adjusted P/E (CAPE) ratios, price-to-book values, and dividend yields:

To be named “cheap”, markets had to be trading below their own historic valuation across all three measures.

Only a handful of stock markets managed to achieve this feat – Greece, China, Hong Kong, India, Japan, Russia and Turkey.

And the expensive? By its reckoning the US, followed rather oddly by Pakistan and Sri Lanka. (The UK is up there, too, judged by two of the measures – by CAPE we’ve still more room to run).

To conjecture wildly, I’d guess the US is so expensive because of the general fear that still persists in the financial world. Despite shares offering better value elsewhere, those with money feel more confident having it invested in America. The weight of this money may have bid up prices to excess.

In contrast, Pakistan and Sri Lanka may be the sort of expensive-looking markets that defy obvious analysis. Perhaps investors are correct to bid up these former backwaters because company profits there are going to explode?

Time will tell.

What to do if you must do something?

Valuing markets is something that looks easy to novices but is notoriously difficult, especially over the short to medium term.

Seemingly expensive markets can continue to deliver strong returns for many years, and even an eventual crash may not be enough to make up for the gains missed by those who bailed out too soon.

For passive investors, the best advice is to make sure you’re globally diversified, and then let your automatic rebalancing take the strain.

Passive investors don’t believe they’re smarter than the market, so they shouldn’t start now.

As for us active adventurers, my feeling is too many people are cautious in the UK for this to mark the top of the bull market, although of course anything can happen at any time to change that. Stock markets are inherently unpredictable!

But I do think with plenty of still-cheap countries around the world, it makes more sense for active investors to favour putting more money abroad instead of hugely dialing down their equity exposure altogether.

While I did take some money out of the market at the start of the year – someday I’ll need to buy that still-postponed property, and I was at well over 90% equity exposure by the end of 2013 – that’s mainly what I’ve been doing.

I haven’t had so much invested in emerging markets in my investing lifetime, for example, and it’s started to come good in the past few weeks. If anything I’m tempted to add more.

As always remember it needn’t be all-or-nothing with an asset class or a region. Investing is a delightful way to be made to look like a fool – it happens to all of us, regularly.

Stay humble.

From the blogs

Making good use of the things that we find…

Passive investing

Active investing

Other articles

Bargain of the week: Geed up by the imminent Tour de France? The Telegraph has tips on how to buy your own road bike for less.

Mainstream media money

Some links are Google search results – in PC/desktop view these enable you to click through to read the piece without being a paid subscriber of that site.1

Passive investing

  • The ETF price war has reached Europe [Search result]FT
  • Are dividends a value strategy? [Ignore US tax point]ETF.com
  • Top-performing funds rarely stay that way – WSJ [featuring Mike]
  • The pros and cons of target-date funds [Heavy!]Wade Pfau / AP

Active investing

  • A profile of Jesse Livermore –  ThisIsMoney
  • Stock pickers are becoming ETF pickers – ETF.com
  • We’ve got it all wrong: Insider traders are heroes – Forbes
  • The secular gold bull market is probably over – Bloomberg

Other stuff worth reading

  • The Londoners cashing in and moving out… – The Guardian
  • …but perhaps we needn’t fear a UK housing bubbleFT Alphaville
  • Would adopting the Swedish rental model help? – ThisIsMoney
  • Setting up a company for just £15 and a £5K loan – ThisIsMoney
  • eBay CEO: eBay will someday accept Bitcoins – Business Insider
  • The robots are coming [Search result]FT

Book of the week: The Oblivious Investor Mike Piper has written a lot of personal finance books over the years, but he’s roped in a co-author and a genuine economist, Austin Frakt, for Microeconomics Made Simple. It’s a delight to recommend one of Mike’s uniquely breezy books that will cross the Atlantic without a translation problem – there’s not a Roth or any other US personal finance quirk in sight! You pay only £3.07 for the Kindle edition.

Like these links? Subscribe to get them every week!

  1. Reader Ken notes that: “FT articles can only be accessed through the search results if you’re using PC/desktop view (from mobile/tablet view they bring up the firewall/subscription page). To circumvent, switch your mobile browser to use the desktop view. On Chrome for Android: press the menu button followed by “Request Desktop Site”.” []

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{ 28 comments… add one }
  • 1 Grand June 7, 2014, 2:31 pm

    Thanks for the opinion TI. I’ve been thinking about what to do given the current environment and I’ve decide to add cash to my portfolio and increase my holding of EM. Currently 30% of the equities in my portfolio are invested in the USA followed by 20% in the UK and I think thats far too much exposure. Thus my strategy for the 2nd year of my portfolio is greater diversification, a move from bonds to cash and to continue to learn more about investing.

    Grand

  • 2 SG June 7, 2014, 5:07 pm

    I am sitting tight on the UK market at the moment and not really interested in trying to call a movement either way. I have bought some EM exposure through ITs over the past few months and am tempted to do more.

    Despite the poor rates on offer, though, I remain happy holding 40% cash (50% if NS&I index-linkers are included). I know this is not the best strategy for maximising current income, but I just like the warm feeling of flexibility it gives me. Am I deranged?

  • 3 gadgetmind June 7, 2014, 5:41 pm

    I started adding ITs in EM and miners a few weeks ago. I’m in no hurry to do much else right now, but the nosebleed premiums on some assets (infrastructure funds, mainly) are giving me cause for concern.

  • 4 Grand85 June 7, 2014, 5:56 pm

    I am not too knowledgeable about investment trusts. It’s an area that I need to get familiar with. There are a number of areas I want to diversify into but are available via EtF’s only. They maybe my answer.

    Grand

  • 5 ermine June 7, 2014, 7:24 pm

    There’s also the fact that the pound is relatively high at the moment (or should that be relatively less beaten up than it has been?) . This leads me to favour foreign assets.

    My HYP already has a heavy home bias, so I’ve looked towards EM (one of the index funds recommended by TA). Russia (yikes). Africa… Does the P/B ratio in the Telegraph really imply investors are are selling the Russian market and Hungary for scrap?

    I am tempted by a Greece ETF but there doesn’t seem anything on the LSE – the Lyxor ETF is domiciled in France with all the associated witholding tax hurt. Though I guess you don’t invest in Greece for the divi, but for the beaten up nature of the joint. And of course the exciting denouement yet to be had when the irresistible force of the Euro contradictions finally overcomes the immovable object of the Bundesbank. Is Greece beaten up enough for that sort of carnage?

    I’d like to get more exposure to the US one day. Its time will come. I’m unconvinced with the melt-up, just too dear at the mo.

  • 6 rodent June 7, 2014, 8:46 pm

    I’m just sticking to my diversification strategy. 40% uk and 40% international and 20% international. I’ll do that until i’m 35 and then move slowly into cash/bonds/BTL.

    http://monevator.com/asset-allocation-types/

    stick to your plan and don’t worry much (but that’s not advice as i’m not a financial adviser)

    http://monevator.com/asset-allocation-construct/

    is another good article.

  • 7 rodent June 7, 2014, 9:26 pm

    Is Warren Buffett seling his american shares?

  • 8 Jon June 7, 2014, 10:32 pm

    Although the US market is slightly overvalued there’s quite a few individual dividend stocks that are fair value like MCD, GE, PM, KO, T, KO, CVX, XOM, PFE and USA REITS typically yield 6%. The market value of S&P 500 is $14T compared to $1.3T for FTSE. USA represents 50% of world market. Any properly diversified portfolio needs to reflect this. I focus on income so i,ve been topping up my exposure to i shares and SPDR dividend ETFs, ticker SEDY and EMDV respectively and also EM local country bonds like EMDL, SEML. It’s a strange period where going through, Equity, bonds, Real Estate are all generally on the high side, the hunt for yield is challenging. Can’t wait to see what happens when rates eventually start to rise !

  • 9 Marco June 7, 2014, 10:37 pm

    For long term investors it doesn’t matter. Even a humungous crash of 60% will only register as a blip if continually investing over the next 20 – 30 years.

    The only scenario which would make a difference is if the markets do a japan.

    However, I think japan’s years of deflation where partly cultural and I don’t see this happening in the rest of the world.

  • 10 dearieme June 8, 2014, 10:50 am

    “It is more important to remain invested in the market where dividends contribute 95% of UK equity returns since 1945 according to the Barclays Equity Gilt Study.” 95%? Really?

  • 11 Grumpy Old Paul June 8, 2014, 11:28 am

    @dearieme,
    Yes. See https://wealth.barclays.com/en_gb/smartinvestor/better-investor/investing-lessons-from-114-years-of-data.html .

    I’m inclined to agree with Rodent’s first comment and Marco’s.
    However, for UK-based investors, there is a lot of political uncertainty over the next year or two with the Scottish referendum, the General Election, the rise of UKIP, the possibility of a referendum on EU membership and a period of minority or coalition government. Then there’s the prospect of real government expenditure cuts over the next five years and the possibility of increasing inter-generational strife. All of which could lead to a sterling crisis, interest rate increases and UK stock market weakness. So an argument for increasing overseas stock market exposure as a defensive move against UK stock market weakness and with a possible further gain from the fall in the value of sterling.

    However, my track record of predicting the future is no better than my ability to select active funds which sustain out-performance!

    Although I’m sceptical about ‘it’s different this time’, I do think that population ageing really will become a major factor in the performance of major economies and arguably has been a major contributory factor to Japanese stagnation over the last couple of decades. Watch out for China where demographic changes and the impact of pollution are taking effect much more rapidly than I’d have ever guessed.

  • 12 Lee June 8, 2014, 12:34 pm

    I rebalanced in January and basically sold off nearly all my US index trackers, and shifted it into EM/Turkey and Asia. Maybe it was a bit too early on the US side as there’s been some growth since. I don’t regret it though as I still have 12% US exposure, which is enough.

    Getting increasingly reluctant to put more into Europe, health and tech funds at the moment, and instead looking at some small AIM plays and continue increasing EM exposure.

  • 13 Lee June 8, 2014, 12:36 pm

    Also, have been thinking about Russia a lot but it would have to be small. It, along with Argentina, I have some kind of instinctive aversion to.

  • 14 Grand85 June 8, 2014, 1:36 pm

    Love the fire starter article. Finally a term to describe me other than weird :). I wonder if there is a high percentage of scanners within the Monevator community?

  • 15 dawn June 8, 2014, 3:27 pm

    I was listening to Warren Buffet being interviewed a few weeks ago on you tube, i think it was CBN news , and he said he didnt think us stocks were overly priced at the moment and in 10 years they will go up and that bonds were a terrible investment right now. he advised keeping enough cash to feel comfortable with and put the rest in stocks.

  • 16 neverland June 8, 2014, 5:23 pm

    This article kind of sums up why I just track, keep saving and rebalance twice a year to be honest

  • 17 Dawn June 8, 2014, 6:34 pm

    @ neverland ,I think your bang on

  • 18 Greg June 9, 2014, 1:06 am

    @dearieme
    “It is more important to remain invested in the market where dividends contribute 95% of UK equity returns since 1945 according to the Barclays Equity Gilt Study.” 95%? Really?

    No. It’s absolutely ridiculous to think like that. It’s simply saying “if you take away a load of your investment each year it does a lot worse than if you don’t.” Drivel that only the finance industry could get away with.

  • 19 helfordpirate June 9, 2014, 9:11 am

    “95%? Really?”

    The distorted maths of this old chestnut is easily debunked!

    Suppose an investment grows by 3% a year and produces a dividend of 3% which is re-invested. It does this every year. I think we can all agree that growth and dividend are having the same impact on our total return.

    Over 100 years, £100 becomes £100x(1+3%+3%)^100=£33,930. Wow!

    If I spend the dividend on wine and women… what a 100 years!

    Over 100 years, £100 becomes £100x(1+3%)^100=£1,900. Agh!

    So a marketing person selling income shares says…

    Capital growth is reponsible for 1,900/33,930=5.6% and…

    Therefore Dividend reinvestment is responsible for 94.4%!

    And you foolishly thought they were equally valuable! Of course this is not to take away from the importance of dividends or indeed any evidence that in fact dividends may have more impact (I dont have the data). But 95% it is not!

    (A lengthy discussion on this can currently be found on the MF Investment Strategies board)

  • 20 Steven June 9, 2014, 10:04 am

    I’m onboard with the passive approach. Also think there’s plenty more upside for equities; given the duration of the preceding multi-year consolidation phase (compare 1965-1982 consolidation). As regards diversification? Just buy a low cost ftse 100 or ftse allshare. Most of the big companies in these indexes are multinational, so you get geographic/currency exposure through the back door.

  • 21 Luke June 9, 2014, 11:42 am

    I was surprised at how few of the people in the Guardian article had bought something cheaper and taken some of their gains. No doubt they’ll feature the same folk in 5 years time as they get even richer 😉

  • 22 Rob June 9, 2014, 2:17 pm

    “Of course this is not to take away from the importance of dividends or indeed any evidence that in fact dividends may have more impact (I dont have the data). But 95% it is not!”

    Lots of people claim this figure is wrong but no one has come up with an alternative figure. I know it sounds wrong, and is quite unsettling, but I have yet to see a better estimate.

  • 23 SemiPassive June 9, 2014, 2:23 pm

    Grumpy Old Paul, a lot of the UK’s problems can be levelled at just about any developed country, plus with the FTSE100 having so much income derived from overseas its not so UK-centric anyway.
    I’ve got quite a strong UK bias in my portfolio but like the higher dividend level, it means even if markets trade sideways for years I’ll still beat cash.
    Where does it go from here? I hope we’ll finally top 7000 for the FTSE100 this year without a big sell off afterwards, but I slashed my SIPP contributions by half around Christmas and currently dripping into just City Of London Investment Trust.

    I can see my Emerging Markets tracker outperforming over the next couple of years, its already ticking up after underperforming in the previous couple of years.
    In summary I am not selling out of any equity funds, but new money will mainly go on mortgage overpayments and a little into a Cash ISA rather than equities for 2014.

  • 24 Dan June 12, 2014, 11:19 am

    An interesting inclusion for next week’s weekend reading: http://www.ft.com/cms/s/0/808189b8-f0a9-11e3-8f3d-00144feabdc0.html#axzz34PjR9Wz7 ?I’d be interested in the accumulator’s views on equal-weighted indexes, as I know that some of the other smart beta concepts (e.g. small cap focus) have been featured in the past.

  • 25 The Investor June 12, 2014, 12:53 pm
  • 26 Dan June 12, 2014, 6:36 pm

    Thanks – I hadn’t until those links. I still think that equal weightings offer benefits over RAFI by capturing the value of rebalancing without the extra research and calculations. The indexes that have equal weights seem to bear this out (http://www.ftse.com/Analytics/FactSheets/Home/DownloadSingleIssue?issueName=UKXEQ), but I haven’t been able to find any UK equity equal weighted trackers. Does anyone know if they exist? (Undoubtedly, with so little competition they will be rather expensive)

  • 27 The Investor June 13, 2014, 8:41 am

    @Dan — Hi again! As discussed in those articles by T.A., the counter-theory as I understand it is that equal weightings may do better because they have more smaller cap exposure compared to market cap weighted indices, but they would accordingly be riskier (so any out-performance is not ‘free’).

    They would also have higher costs — because someone has to pay the cost of the re-balancing you mention to keep them equal weighted, in this case the index fund. (Also, the main benefit of rebalancing is across asset classes as opposed to within them; you probably know this).

    I have no strong view either way, but I doubt it will make a vast amount of difference except at market extremes. (E.g. In a dotcom boom type scenario I’d rather be equal-weighted, but that’s because I’m a nefarious active investor who thinks he sometimes knows better the market! 🙂 ).

  • 28 The Accumulator June 14, 2014, 11:09 am

    @ Dan – To the best of my knowledge there aren’t any UK equal weighted trackers out there, probably for the same reason that there aren’t any genuine UK small cap trackers – it’s expensive and there isn’t enough demand.

    The RAFI trackers are style or factor plays e.g. they try to capture the value premium. An equal weighted fund is the same thing: a factor play that tilts towards the small cap premium.

    If there is any rebalancing premium then any of these funds should be able to capture it. Although everything I’ve previously read suggests that any rebalancing premium can’t be relied upon – no different to any other premium then.

    Historically the value premium has been stronger than the small cap premium but small-value is where the action is strongest. I use the Aberforth Smaller Companies Investment Trust (ASL) to give my portfolio UK small value exposure.

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