Current market valuations – Dec 31 2018
Where are we today with the stock market? Cheap, normal, expensive? US versus Europe versus Japan, Australia? Real estate? Gold?
This post is the sequel on
If we can combine the current level with the average future returns, we can come to a conclusion on the expected total return of each class, and choose an appropriate index for that asset type.
I am not looking for an exact measure or a number with two digits after the decimal point, like ‘the market is 12.65 % overvalued’. I want to have a basic idea e.g. ’20 % too expensive’ or ’10 % too cheap’. Markets can be far too expensive or cheap during multiple years so it only makes sense to have a rough indication of where we are.
A stock market level is related to the value of that market at a given moment. 2500 for the S&P 500 could be expensive today (2018) but cheap in 2025. This market value fluctuates together with all the economic activity of all companies in the market, but here too I want to simplify to the extreme. Lets ignore the ups and downs of a growing or contracting economies, and assume that the markt will grow at a constant pace for the next 15 years. Because, if you have an investment horizon of decades, it doesn’t really matter that there is a recession in 2019 followed by 5 years of growth followed by a recession followed by growth. You want to know what your investment could be after all that, 15 years in the future.
So instead of the blue ‘real economy / correct market value’, when it comes to predict the future, I stick with the red dotted line ‘average market growth’. That’s the baseline of where the market should be.
Let’s try to draw this line for the S & P 500.
Where did this nice smooth exponential line suddenly come from? I have drawn an exponential growth line in excel using:
- the ‘Buffett Indicator’: ratio of total market cap vs GDP growth. See here.
- And here for the regular Shiller PE (instead of Shiller CAPE)
- the “Average of the Four Valuation Indicators” found here
If you draw a simple exponential line through the valuations you get the chart above.
Conclusion on the S&P 500 level
A correct level for the S&P 500 at the end of 2018 could be roughly estimated at 2200. It is obvious that we have been in a market bubble during 2017 and 2018, and in Q4 2018 we have simply come back to earth from our bubble. This is not a ‘crash’, it is a reversal to the mean.
You can technically call it a bear market if you insist, but the market went from average levels to super – high (2900 in 2018) in less than 2 years ( + 31 %); when the market returns to more normal levels at the end of 2018, there is panic and wall street calls it a bear market.
S & P 500 levels last 6 years
|End of year||over (+) or under (-) valuation|
|2014||+ 15 %|
|2015||+ 8 %|
|2016||+ 13 %|
|2017||+ 28 %|
|sept 2018||+ 34 %|
|2018||+ 14 %|
- 2012: After the crisis of 2008 stock market levels were low and until 2012 we had an undervaluation.
- 2013: The FED took action, kept interest rates very low, and introduced their ‘Quantitative Easing’. We had a super year: the S&P500 climbed 29 %. And we went from underpriced to overpriced in one year.
- 2014-15-16: We remained a bit overpriced the next 3 years.
- 2017: we lost touch with reality, added another 19 % to an already over-expensive S&P 500.
- 2018: The trend continued, we went from 28 % too high to 34 % too high and everybody continued to celebrate at the party until the lights went out. We came back to earth in Q4 and we end 2018 at a + 14 % level.
I don’t know if I understand anything at all about gold and where the price should be. I can draw an exponential curve through the price chart (symbol XAUUSD=X) which looks like this
It looks like we are pretty much at a correct price today.
Not easy to make a call on the correct pricing. Given that returns are higher in the US than in the rest of the developed world, I will try to make a judgement only on the US REIT level. Also given that we have had a consistent period of low interest rates, that will have driven up the prices and value of real estate property, so I would expect some overpricing. The dividend yield tells a similar story, with a yield today at 5 %, where a normal yield is 6 – 6.5 %, again pointing to a 15 % overpricing. Drawing an exponential curve on the S&P 200 REIT chart looks like this:
I have on purpose not included the period before 2007 for this curve-fitting because we all know the history: the housing bubble of 2003 – 2007 distorts all numbers. The chart represent the ‘gut feeling’ that we might be a bit overpriced in this market too.
Bonds obviously can be over- or underpriced. If you own single bonds and keep them until maturity you are not impacted (except for the opportunity loss – receiving low yields while your money could earn more). But I look at the investment in the case of using an ETF rather than individual bonds, and the ETF prices will increase or decrease in sync with interest rates. Main variable is the long-term interest rate.
The target interest rate of the FED is 0.5 % higher than today (end 2018) Let’s just for the sake of simplicity assume that the long-term interest rate will also increase another 0.5 %. A ten year bond with a coupon of 3 % would lose 4% in value in a 3.5 % environment. So let’s assume that our bond funds are 4 % overpriced.
Based on Shiller CAPE and PE, an acceptable value is 21500.
Using th same metrics (stock market / GDP, Shiller CAPE and PE) I come to a correct price for the All Ordinaries Index of 6164 AUD.
Europe is a very diverse set of countries, each with their individual market level. Some stock markets have been slaughtered (Italy, Belgium), other are doing fairly well. Depending on which mix you take, you get a different number. I calculated an average of Spain, France, Germany and the Netherlands and came to a estimated correct level for the Euro STOXX 600 of 3366.
Calculation of the Russell 2000, again based on Shiller CAPE and PE, gives me a fair price of 1150. Which means that small caps are still overvalued (a lot) at their end-of-year (2018) price level.
Overview of markets and expected returns
All these numbers may seem confusing but the purpose of this exercise is to get an overview of
- where are we today with each market
- what is the average exected return (if you would start from a perfectly correct level)
- the combination of these two: what can you expect given the current starting point combined with the annual return
|All returns before Inflation adj and excl expenses||Today's position (+ = overpriced / - = underpriced)||Long-term average TR||Return 3Y||Return 5Y||Return 10Y|
|S&P 500||+ 13 % (at 2500)||8.7 %||4.4 %||6.1%||7.4 %|
|BRK||- 9 % (at 192)||10 %||13.3 %||12 %||11 %|
|Gold||- 5 % (at 1282)||6 %||7.9 %||7.1%||6.6 %|
|Corp Investm Grade Bonds||+ 4 %||4.4 %||3.0 %||3.6 %||4.0 %|
|Equities Australia||- 5 %||8.3 %||10.1 %||9.4 %||8.8 %|
|Equities Europe||- 11 %||6.3 %||10.6 %||8.9 %||7.6 %|
|Equities Japan||- 5 %||6.6 %||8.3 %||7.6 %||7.1 %|
|Gov Bonds US||+ 4 %||4.3 %||2.9 %||3.5 %||3.9 %|
|Small Caps||+ 16 %||9.0 %||3.6 %||5.7 %||7.4 %|
|US REIT (developed market)||+ 12 %||8.5 %||4.6 %||6.2 %||7.3 %|