I have written before about one of the most important changes I believe is needed in thinking about investing over the last few decades: Historical Stock Returns.
My belief is that there has been a fundamental change in the valuation of stocks. Long term data contains a problem in that we have generally realized that stocks are more valuable than realized 100 years ago. That means a higher based PE ratio is reasonable and it distorts at what level stocks should be seen as very overpriced.
It also depresses expected long term returns, see my original post for details.
Jeremy Grantham: The Rules Have Changed for Value Investors
Since 2000, it’s become much more complicated. The rules have shifted. We used to say that this time is never different. I think what has happened from 2000 until today is a challenge to that. Since 1998, price-earnings ratios have averaged 60 percent higher than the prior 50 years, and profit margins have averaged 20 to 30 percent higher. That’s a powerful double whammy.
Diehard Ben Grahamites underestimated what earnings and stock prices would do. That began to be a drag after 1998.
I believe he is right. I believe in the value of paying attention to historical valuation and realizing markets often go to extremes. However, if you don’t account for a fundamental shift in valuation you see the market as overvalued too often.
So why have prices risen so high without a hint of euphoria — at least until very recently — or a perfect economy? My answer is that the discount rate structure has dropped by two percentage points. The yield on stocks is down by that amount and bonds too. The market has adjusted, reflecting low rates, low inflation and high profit margins.
Again I agree. Our political parties have aided big business in undermining market through monopolistic market control and that has been consistent (and increasing) for decades now. It makes stocks more valuable. They have moats due to their monopolistic position. And they extract economic rents from their customers (granted they put a large amount of those ill gotten gains into executives pockets but even so they gains are large enough to increase the value of the stocks).
On top of these strong forces we have the incredible interest rate conditions of the last decade. This is the one that is most worrisome for stock values in my opinion. It servers to boost stock prices (due to the poor returns for interest bearing investments). And I worry at some point this will change.
There is also likely at some point to be a political return to the value of capitalism and allowing free markets to benefit society. But for now we have strong entrenched political parties in the USA that have shown they will undermine market forces and provide monopolistic pricing power to large companies that provide cash to politicians and parties in order to have those parties undermine the capitalist market system.
I believe the stock market in the USA today may well be overvalued. I don’t think it is quite as simple as some of the measures (CAPE – cyclical adjusted PE ratio or market value to USA GDP) make it out to be though. As I have said for several years, I believe we are currently living through one of the more challenging investment climates (for long term investors seeking to minimize long term risk and make decent returns over the long term). I still think it is best just to stick with long term portfolio diversification strategies (though I would boost cash holdings and reduce bonds). And since I am normally light on bonds and high on stocks, for someone like me reducing stock holding for cash is also reasonable I believe (but even doing this I am more in stocks than most portfolio allocations would suggest).
Related: Monopolies and Oligopolies do not a Free Market Make – Misuse of Statistics, Mania in Financial Markets – Interview with Investing Blogger John Hunter