Summary of 3Q/2017: Are U.S. Stocks Overvalued?
Note: All performance figures quoted below are based on MSCI Indexes using data provided through the Dimensional Returns 2 program.
The third quarter of 2017 was yet another great quarter for global equities. The U.S. Broad Market was up 4.5% for the quarter and 14.0% year-to-date. The leading segment for the quarter was small growth at 6.3%, but on a year-to-date basis, large growth leads at 19.7%.
International developed markets outperformed the U.S. with 5.6% for the quarter and 19.2% year-to-date. Emerging Markets did even better with 7.9% for the quarter and 27.8% year-to-date. Both of these asset classes were bolstered by a weakening of the U.S. dollar, both on a quarterly and a year-to-date basis.
One of the drivers of the gains in the U.S. market is the anticipation of lower corporate taxes. Although it has been more than eight months since President Trump was inaugurated, we have only seen a general outline of a tax plan that was recently announced (with some important details still to be negotiated), and based on the failure of the Republican health care bill, there is a clear possibility that it may not pass both the House and the Senate. What is not clear is exactly how far the market would fall if this scenario were to happen.
This brings us to a question we hear quite frequently: Are U.S. stocks overvalued? Let’s begin by saying that we use the terms “overvalued” and “undervalued” with great reluctance because they imply that the market is now irrational and there will inevitably come a time when the market will return to rationality. As the great economist John Maynard Keynes said, “The market can remain irrational longer than you can remain solvent.” A second problem with the idea of overvaluation is that it implies that the expected return (at least for the short-term) is negative, so smart investors should stay out of the market until expected returns become positive. For most investors, including ourselves, the sensible approach is to assume that every day going forward from today has the same expected return, and if markets are working properly, this return will be positive and reflective of the degree of risk taken. Must this return be equal to the long-term historical return? Not at all.
The proponents of overvaluation can point to the Shiller Cyclically Adjusted Price-to-Earnings Ratio (based on ten years of earnings) which has now reached a level last seen only in the run-ups to the Crash of 1929 and the Dot Com crash of 2000. And yes, the U.S. does have the highest CAPE level in the world, according to Professor Shiller. The high level of CAPE is partially justified by the extremely low level of interest rates that would support abnormally high stock valuations. Since stock valuations are simply discounted future cash flows, to say that stocks are overvalued implies that either the anticipated future cash flows are too high (i.e., the future growth assumption is too optimistic) or the discount rate is too low or both. The discount rate includes a risk premium (the additional risk imparted by stocks over safe investments like Treasury bills) that, unfortunately, is unknowable. A claim that the market is under-discounting future cash flows is equivalent to saying that the market is understating the risk associated with equities. In his prescient book Irrational Exuberance, Professor Shiller spoke about a self-reinforcing circle of rising prices followed by increased optimism leading to even higher prices, and he warned of how the circle can run in reverse.
To be clear, Shiller is not sounding any alarm bells about this market, as seen in this CNBC article and video where he points out the differences between today’s market and the pre-crash market of 1929 where investors were commonly margined at a ten-to-one ratio. One similarity we see between today’s market and the late 1990s market is the prevalence of a concept that is extremely hyped up. For today’s market, it is cryptocurrencies and the underlying blockchain technology. One poignant example is Bioptix (a small company specializing in licensing fertility hormones for farm animals) recently changing its name to Riot Blockchain.
At Clarity, we believe that a prudent way for investors to engage with this market is by starting with a sensible allocation and rebalancing when warranted. A sensible allocation is one that the investor would not bail out of in the event of a bear market. Rebalancing is best accomplished with cash flows—investing deposits in underweight asset classes and selling from overweight asset classes to meet withdrawal needs.