Are stock prices too high? What should investors do about it?

24 Oct Are stock prices too high? What should investors do about it?

There’s a lot of talk among market pundits about how pricey stock are. Some even suggest we’re experiencing an equity market bubble.

It’s not hard to understand why some people think this and that a ‘crash’ will inevitably follow. We’re now over eight years into the current rising market and there are increasing concerns that equity prices may be too high.

One of the more reliable metrics used to measure how pricey equities are is the Cyclical Adjusted Price Earnings (CAPE) ratio. It was created almost 30 years ago by Nobel Prize winner Prof. Robert Shiller and his colleague Prof. John Campbell. The CAPE ratio is the inflation-adjusted stock price, divided by the previous 10-year average of real earnings.

An above average CAPE ratio is typically followed by below average equity market return over the next 10 years and vice versa.

The CAPE ratio for UK equity is now 15.8 (as at May 2017), compared to the historical average of 12.8. The current level is not the highest we’ve seen. It ranks in the 77th percentile, which means CAPE has only been higher than the current level in 23% of times since 1927!

The CAPE ratio for the US stock market is a little more worrying. It’s currently above 30, compared with an average of 16.8 since 1881. It’s been above 30 in only two other periods: in 1929 when it reached 33, and between 1997 and 2002, when it soared as high as 44! Both of those instances were followed by a very sharp decline in equity prices.

This has caused pundits to question whether we’re due another sharp decline in the stock market. Sadly, as useful as CAPE is, it doesn’t lend itself to crystal ball gazing in the way that many try to use it.

Yet, there’s a lot about equity returns that’s unexplained by CAPE – or any other equity price metric. Historically, a price metric like CAPE has failed to explain more than two-thirds of changes in share prices.

Indeed, the father of CAPE himself admitted in a recent article that, “…current valuations make the market vulnerable. But it took more than high valuation numbers to precipitate those ugly declines in the past. The other ingredient was mass psychology….But the result is that while valuations remain very high there just doesn’t seem to be much evidence that many investors in the United States stock market are actively worrying today that other investors are on the verge of selling. Mass opinions may well change, but for now, in the critical psychological dimension, the stock market does not closely resemble the market in the dangerous years of 1929 or 2000.”

Mass psychology is fickle, much harder to measure and mostly completely unpredictable. But it is often the most significant reason for equity market movements.

The price of stocks gives us a vague idea where we are in the market cycle. However, all it really tells us is the probability that equity returns are likely to be below or above average over the longer term. By the very definition of ‘average’, we should expect returns to fall somewhere above and below the average!

Given the cyclical nature of returns, we should expect share prices to rise and fall from time to time. Trying to predict exactly when equity markets will experience a sharp decline is a fool’s errand. Being out of the market completely (meaning selling down all funds for cash, whether bonds or equity funds) means trying to time the market. We know this is impossible to do consistently. If you try to avoid a potential fall in stock prices by staying out of the stock market, you’ll almost certainly miss out on too much return in the process.

The truth is we no idea if we have a stock market bubble or if it’s about to burst and neither do any of the pundits. One thing I’m fairly certain of is that the one bubble that needs busting is the inflated ego of those who think they can predict what equity markets will do next!