The Markets Don't Match Reality, According to These Metrics

Many readers often argue that true investors should not focus on the day-to-day fluctuations in the markets, which are of greater concern to traders. Instead, they advocate for a buy-and-hold strategy when it comes to stocks. There’s some validity to this perspective: after all, most fund managers underperform the market, so what chance does an individual have? The better option, they suggest, might be to simply invest in an index fund.

‍

However, even the most committed long-term investors should reconsider their portfolios when market prices deviate significantly from reality. Examples of such instances include the dot-com bubble, the Covid-19 market crash, the near-zero yield on bonds, and the speculative bubbles in SPACs, cannabis, and clean energy stocks during late 2020 to 2021. The critical question is how one should assess when prices are truly out of line.

‍

Three common metrics for evaluating this are the CAPE (Cyclically Adjusted Price-to-Earnings ratio), the forward P/E (Price-to-Earnings ratio based on forecasted earnings), and the Fed Model, which compares stock earnings yields to bond yields. All three suggest that large U.S. stocks are currently overpriced—not only in comparison to historical levels but also relative to smaller stocks, international equities, corporate bonds, and U.S. Treasurys.

‍

If these indicators are accurate, the recent rebound in large-cap stocks could be a deceptive rally, meaning it might be wise to shift away from the largest stocks.

‍

CAPE, developed by Yale Professor Robert Shiller, is a popular metric among long-term investors. The S&P 500 is currently valued at 35 times the average earnings of the past decade, adjusted for inflation, making it the third most expensive since the late 19th century. This is even pricier than the peak in 1929, leading to the conclusion that the S&P 500—and particularly its largest components—are highly overvalued.

‍

The forward P/E ratio, which is based on analysts' earnings forecasts, has been tracked since 1985 by IBES (now part of the London Stock Exchange Group). Like the CAPE, the forward P/E suggests that stocks are currently very expensive, though slightly cheaper than during the peak years of 2000 and late 2020.

‍

The Fed Model, coined by strategist Ed Yardeni in the late 1990s, compares the earnings yield (earnings per share divided by price) of stocks to bond yields. It is often used to determine whether stocks are attractive compared to the safer alternative of Treasurys. At present, the Fed Model indicates that stocks are quite overvalued. A month ago, when 10-year Treasury yields were lower, the S&P 500 was at its most expensive relative to bonds since 2002.

‍

Given these indicators, the logical course of action seems to be selling large-cap stocks. However, long-term investing isn’t always straightforward. Each metric has its strengths and weaknesses, and relying solely on these can sometimes lead to poor investment decisions.

‍

For instance, the CAPE ratio surpassed its 1929 peak in July 1997, shortly after Federal Reserve Chairman Alan Greenspan famously warned of “irrational exuberance” in the markets. Despite this, an investor who bought into the market at that time would have achieved an annualized return of 7% above inflation—a performance that surpasses the average returns of U.S. stocks since 1900, according to research by Elroy Dimson, Paul Marsh, and Mike Staunton.

‍

Moreover, the CAPE has been below its long-term average only once since then, signaling a buy opportunity in March 2009 that proved highly successful. However, investors relying on the CAPE likely found it challenging to hold onto their positions as the S&P 500 quickly rebounded to levels deemed overvalued.

‍

For the CAPE to return to its long-run average, an extreme market crash would be necessary. A more plausible explanation for CAPE's elevated levels is that stocks have generally been valued higher over the past century, thanks to easier access to equities through mutual funds and ETFs, rising wealth, and falling real interest rates since 1980.

‍

Forward P/E ratios have their limitations too. They depend on analysts' forecasts, which are often influenced by Wall Street’s consensus. Long-term investors should approach such forecasts with caution.

‍

The Fed Model, while useful, has also produced some misleading signals. For example, in November 2007, it suggested that stocks were their cheapest compared to bonds since 1985—just one month before the global financial crisis began. That proved to be one of the worst times to buy stocks and sell Treasurys.

‍

Despite their flaws, these measures offer valuable insights. Historically, when these indicators show that stocks are expensive, subsequent returns over the next decade tend to be lower. Conversely, when they suggest that stocks are cheap, future returns are generally higher. From 1985 onward, both the CAPE and forward P/E ratios have closely correlated with S&P 500 returns over the next 10 years, with the Fed Model being slightly less reliable. CAPE and forward P/E ratios explain about 85% of the variance in returns, while the Fed Model accounts for 74% of the performance of the S&P 500 versus Treasurys since 1991 (although it failed to accurately predict market movements before that).

‍

Critics might argue that these measures worked well only in the specific market conditions since the 1980s and might not be as effective if those conditions change. Additionally, they don’t perform as well over periods other than 10 years, and their success is somewhat skewed by the particularly poor performance of the market from the dot-com bubble to the financial crisis. Furthermore, they can’t be tested beyond 2014, as there’s no 10-year record available yet.

‍

While factors like the economy, politics, and geopolitics undoubtedly play significant roles in market performance, these three metrics provide a broad directional guide without considering those factors.

‍

The concept of a margin of safety, as articulated by Benjamin Graham, applies to the market as a whole, not just individual stocks and bonds. Investing when valuations offer little to no margin of safety can lead to disappointing results. Currently, there’s a noticeable lack of such safety in the market.

‍