Is the Stock Market Really So Overvalued by Any Measure?
Whenever we are in a mature bull market, and we get indications that it may be over, it’s a given that valuations will be out of line. How much does this matter though?
Stock market analysts pay quite a bit of attention to a number of fundamental indicators which may suggest a market bottom or top. Given how far the market has come in the last 10 years or so, we may expect a lot of people to be combing the numbers and coming up with why we may have reached our peak and why we may be in the midst of a reversal.
The term that’s thrown around in these times is overvalued, where it’s assumed that various criteria related to business performance of stocks in an index is what really drives share prices.
It is true that such things are looked at, and no one would argue that such things do not influence markets at least somewhat, where for instance investors may see the numbers looking like they are too high and have this influence their market sentiment. When sentiment reverses, prices are often not too far behind.
We do not want to take an oversimplified view of what drives stock prices though, and especially do not want to treat stocks as merely vehicles to earn income with. In reality, the profit potential with stocks is based upon capital accumulation more than it is in earning dividends.
Stocks are a Different Animal Entirely
Capital accumulation and dividend growth may be somewhat related, but are driven by two entirely different things. Dividends are of course driven by business performance, while the price of a stock is primarily driven by the supply and demand of the stock itself.
If certain fundamental indicators are historically high, where if this were the only influencer or the major one, then these indicators wouldn’t just predict a correction, they would cause one. When stock prices rise faster than business profits, we of course see a dilution per share of these earnings, but provided that the demand for the stock remains high enough, it will continue to propel share prices higher.
There are always corrections in markets though and no bull market lasts forever. Given the length of the current one, we may rightly ask whether we have reached the top or not. The fact that we pulled back by around 20% in the final months of 2018 adds to this speculation and perhaps even gives it teeth.
Investors have different comfort levels though, and during a correction, those who have exceeded their comfort levels will exit or pull back from the stock market, and we could call this the market achieving a new equilibrium of comfort. Those who are uncomfortable with, say, market valuation, or any other factor that may bother them, will vote with their feet, and when the dust settles, we will end up with a new equilibrium.
Momentum certainly plays a role in this, and when we get to a point where there is enough pressure on the sell side, this in itself can create its own trading weather so to speak, and if this momentum reaches a critical mass, bear markets can be created where market sentiment becomes beat down and may take some real time to create enough positive momentum to turn the tide again.
Have we reached this point now, or rather, are we on the brink of a bigger decline than the 20% we just saw in Q4 of 2018? This is a complex question and one that really requires a wait and see attitude, in addition to whatever analysis we wish to do. On the side of remaining bullish though, the impressive recovery in just a couple weeks from our recent low on December 24 does bode well, so far anyway.
It is almost a given that during extended bull markets, we will see higher fundamental ratios such as price to earnings. During these times, share prices just rise faster than things like earnings or other measures of business performance.
Correlations Can Only Take You So Far
We need to be careful not to assume causation here though, which we do when we assume that high fundamental ratios will somehow cause corrections and bear markets in themselves. Sure, they may play an influential role, and eventually things will correct, but this does not mean right now, in the first quarter of 2019 or maybe not even during the coming year.
The reason is that, unlike bonds and preferred shares, the reason why people invest in stocks is not to achieve certain yields, but to enjoy capital appreciation. This is what makes stocks different from income class investments.
Analysts are willing to dig pretty deep to present a picture of overvaluation, even looking at things such as the ratio of share price to sales, even though sales don’t play a direct role in things like yields and we can just look at the yields themselves with more relevance.
Many of these factors are on the high side right now, which is causing many people to view the market as overvalued indeed. What does overvalued mean though? If one is investing in stocks to achieve certain yields, then prices are indeed overvalued, without question.
This is not why we invest in stocks though. Stock prices are not determined by yield valuation, they are decided by investor demand. The proper value of a stock is expressed in absolute terms by its trading price, the price that the participants have decided among themselves as appropriate and correct right now.
Where prices are heading though is another story and the crux of the matter when it comes to predicting ends to bull or bear markets. While we should not ignore predictions based upon valuation, at the same time we need to realize that the market participants decide such things, and will decide what weight these numbers should be given.
If it turns out that these participants indeed feel that share prices are too high to the extent that supply overcomes demand enough to throw us into an actual bear market, or is driven by any concern that would cause a net outflow of capital from the stock market, then prices will fall. We’re not there yet, in spite of the efforts of these number crunchers, because the market itself always has the final word.
Editor, MarketReview.com
Robert really stands out in the way that he is able to clarify things through the application of simple economic principles which he also makes easy to understand.
Contact Robert: robert@marketreview.com
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