Valuation Check

June 19, 2017

 

At 96 months, the current economic expansion is one of the longest on record, leaving many markets participants, ourselves included, to wonder if it could be nearing an end.  Of course, at 96 months, the current economic expansion is not the longest US expansion.  During the 1990’s the US experienced a 120-month expansion, and in the 60’s the US experienced a 102-month expansion.  Nonetheless, expansions of this length are not common, nor are returns that we have had over the past 12 months.  Given the length of the recovery and the excellent market returns over the past 12 months, there is a natural assumption the stock market must be incredibly overvalued.  In this article we will review some of the statistics to answer the question, are we in a bubble?

 

Stocks have now tripled since the market bottom in 2009.  Some have a hard time believing that the market has been doing that well, while others look at the returns of the last 8 years as evidence that we are in another bubble.  But measuring from the bottom of the crisis is not a great way of looking at returns.  If we take a step back and look at the longer-term picture, stocks are doing exactly what they should be doing, returning to the 7.3% long-term compound annual growth trajectory that has been tracked all the way back into the 1800s by Jeremy Siegel’s “Stocks for the Long Run”.  From this wider point of view, it appears that stocks have been normalizing, reverting to their long-term mean, rather than climbing to a new bubble.

 

Looking at today’s market statistics also show that the market is expensive, but not necessarily in a bubble.  As of 5/31/17 the P/E or Price/Earnings ratio on the S&P 500 was 19.6X trailing 12 months earnings and was 18.3x expected 2018 earnings.  The question becomes whether the rich valuations are warranted and there is an argument for today’s valuations.  Earnings have been growing, and earnings are projected to accelerate through the end of 2018.   The most recent change in the trend of leading economic indicators is a surge to the positive.  Retail sales are booming, unemployment low, personal income is on the rise, and American’s FICO scores have never been higher.  It is somewhat ironic that the news still seems to characterize America’s economy as anemic, when, by most measurements, the economy and stock market are doing incredibly well.

 

As value investors, we don’t like to see high valuations and we continue to use strategies to choose the companies with the best fundamentals.  However, as we have said before, it is important as stock investors to remember what we are investing in.  We are investing the ingenuity of thousands of companies and employees as they create value through innovation and service delivery.   Earnings drive stock prices, and the earnings growth over the long term has been incredibly consistent.  The 90’s were a time when investors no longer cared about earnings.  That was truly a bubble.  While current valuations are somewhat high, they do not appear to be in bubble territory.

 

The market will pull back at some point, but we continue to believe in our process as we navigate this market.  We continue to be focused on the long-term plan and asset allocation, and continue to focus on fundamentals rather than trying to time the market. Last July a host of Wall Street experts, including Jeffery Gundlach, Bill Gross, Jeremy Grantham called for investors to sell everything as the market had topped.  Those who listened to the experts missed the outsized returns of the last 12 months and hurt their returns significantly.  Market tops are incredibly difficult to predict, and missing excellent years can be even more damaging to long-term returns as avoiding the drops.  We remain cautious and committed to our long-term plans.

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