Are stocks expensive? What should you do about it?

Welcome to Part 2 of my exploration of investing at "all time highs". This week, I'm looking into high valuations and what it means for investors nervous about investing when stocks are expensive.

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Transcript

Speaker 1: 0:09

Hello and welcome back to the Canadian Money Roadmap Podcast. I'm your host, evan Newvill. On this week's episode we're looking at part two of investing at all time highs. But this week we're taking things a little bit further and looking at valuations as opposed to just the price level of the stock market. Welcome back to the podcast. If you have not listened to last week's episode on investing at all time highs, I'd recommend that you start there and go back and listen to that quick episode before looking at this one, because last week we looked at how returns have been positive on average for investors who invested at all time highs on a one, three and five year basis. But this only looked at the index and the price level, not necessarily the valuation of any stocks within the index. So this week I'm going to talk about valuation and how that can affect future returns. Now I do want to say that there is plenty of debate on these topics, and so what I'm going to present here is just a summary of the empirical evidence that I've taken a look at and what my conviction is and what my belief is. There's a lot of opinion when it comes to valuation and whatnot, so I like to base my feelings on this topic, on evidence and a whole lot of history, as opposed to recency bias or get feelings or anything like that. So, anyways, that's just my little caveat getting into valuations here, because this topic is a little bit less black and white. So anyways, let's get started here. Number one let's just talk about what do I mean by valuation Is just whether something is deemed to be expensive or cheap, or a high relative price versus a low relative price. And that relative part is critical because what makes a stock expensive? It isn't the simple price of a share. So if stock A has a $200 price per share and stock B has $50, that doesn't mean the $200 one is more expensive, because the price does not tell you how many shares are outstanding. It doesn't tell you anything about the growth of the business. It doesn't tell you anything about the profit. It doesn't tell you anything about the assets of the company, nothing like that. So the price by and large doesn't really actually tell you anything. It's always the price of a share relative to something else. So this is why I often use the language of relative price. So this is relative to something like cash flow or book value or earnings, or even dividend yield. Dividend yield is relative to the stock price at any given time. So when a stock has a very high price to book value, or we call that a PB ratio, that means it is more expensive than a stock that has a low PB ratio. Pe ratio is priced to earnings Same thing. You can take a look at all of these things and compare them to something else. So what a lot of people do is they group everything together, just like the index, and they figure out what the average valuation is of the entire group and compare that to other times in history. However, history is less useful as a guide because everything changes. A lot of people have looked at the current market and seen a lot of big tech companies and compared it to back in 2000 when there was a big stock market crash because of all the tech companies that went bust at that time. The difference is a large number of those tech companies back in 2000 were essentially ideas. They weren't real businesses that were making any money. Now, some of the biggest companies that are at the top of the stock market and driving the returns of the market for the last decade or so there's one of the most profitable companies we've ever seen in the history of the planet. The things change and valuations change based on expected cash flows in the future and all sorts of different things. Because, again, a price of a stock is based on a few fundamental things and a bit of hopes and dreams about the future. Every participant in the market is buying and selling based on what they think it is and today's price is the culmination of everyone that's feeling really good about the stock and really negative about the stock. So valuation from my perspective is less of a situation of, well, this stock is overpriced, or this stock is underpriced, or the market is overpriced and the market is underpriced. So from my perspective the price is more often than not correct based on the millions of participants in the market buying and selling based on what they know about the stock and what they think about the future. So the thing that largely moves stock markets then, as a result, because information is public for publicly traded stocks or surprises. So I'm kind of going off script here a little bit, but the original point here was that history is less of a useful guide because of everything that changes over time. So history, you know, stock market is worth X versus 30 years ago it was worth Y. You know that's more likely to use just as an interesting data point than anything that's really instructive. So what should we actually do? Instead for looking at valuations, I would recommend looking within the stock market and comparing between securities to find the groups that might be expensive or have high relative prices versus the groups that might be inexpensive or have low relative price. This is how we get to the high level classification of value and growth stocks. Value essentially means that you're getting a good deal relative to other stocks based on the metric that you choose, so something like price to earnings ratio or price to book ratio. These are the lower priced stocks relative to those metrics. Growth stocks would be the more expensive stocks in those metrics, so you'd be paying today for the growth that you hope to get tomorrow. This is where it is much easier to get more hype and speculation. The prices of these stocks are more reflective of the idea of what is to come, so there can be much more room for error and bigger moves when there are surprises on earnings or sales or anything like that. Big moves can happen in both directions because growth stocks are usually priced for the best case scenario. Those value stocks are priced for low expectations. Right, if you have low expectations and they beat them, guess what? You're going to have a really nice, pleasant surprise. But if you have a growth stock that has really really high expectations and they meet those really really high expectations, stock prices isn't going to really move a whole lot. We saw that recently with Nvidia. I talked about that on the podcast, just as an example. It was a crazy high valuation and they had crazy high earnings and the stock went down because because that price or that that expectation was already baked into the price already today. So this is again back to that idea of the price is often right, quote, unquote right based on the collective assumption of the future. So why? Why do we bother looking at valuation here at all? Well, this matters because value stocks have historically outperformed growth stocks. There are periods of time where that definitely is not the case, and the last few years. Well, going back to that decade between 2010 and 2020 ish, that was not the case. But if we go back all the way again this is looking at the US market, but going back to 1927, the average outperformance for value stocks in all of those years is 4.4 percent. It is not every year, it is not every decade, by no means. But for long-term investors the value premium has been reliable over a long enough period of time. The challenge is you have to stay in your seat to get it, and the appeal of getting in and out and jumping between value and growth can be quite high. So, anyways, our stock's actually expensive today. This is kind of the million dollar question. So, as a result of the idea of relative price, there's always stocks that are less expensive than others. Like I said, there's always going to be value stocks and always going to be growth stocks, because if we look at valuation between securities as opposed to the market as a whole, there's always opportunity to invest in value stocks. So I like to take a look at how expensive growth stocks are relative to value stocks, just for that general data point. Because within the market as a whole, the very expensive or high relative price stocks kind of drag up the average compared to everything else. So if we're just going to look at the gap between growth stocks and value stocks today or at the end of last year, the most expensive stocks are pretty much the most expensive they've been relative to any time in the last 30 years and that takes a look at a metric called the PE ratio, so that's the price to earnings ratio. This is data coming from JP Morgan Guide to the Markets, and this happens from time to time. The current forward PE so forward means that it takes a look at the anticipated earnings for companies going into the future. Again, no one knows the future, but there's all sorts of forecasts that all these companies do, and analysts and whatever, and so the aggregate assumption of what the earnings are going to be over the next 12 months versus the price says that for growth stocks, the current forward PE is about 26 and a half times earnings, whereas for the value segment of the market it's only 14.9. Let's call it 15 for easy numbers, so that gap is pretty big. There are many other metrics that you could take a look at too to compare, but broadly speaking, if you look at the market on average, the really expensive stocks are really expensive, and so if you're looking into that idea of value stocks outperforming growth stocks, you might say well, I'm just going to get out of the market and I'm just going to have cash. Unfortunately, this is really tough to do as well. There's plenty of studies on this. I'm not going to get too into the academic side of things, but being able to time. We call it the equity premium. So that's the idea of owning stocks versus bonds or versus cash. Being able to time the equity premium based on valuation has been incredibly difficult and the odds of success there are really poor, and timing the valuation premium is also really difficult. So both of these factors the equity premium and the value premium are best achieved by staying in your seat and owning it all the time, based on your risk profile and timeline and all these other things that I always talk about. So, unfortunately, this is kind of a good news. Bad news thing is that valuation matters, but timing your ins and outs of the market based on valuation is almost impossible. So what do we do about it? So, number one, if you're a passive index investor, so someone that owns the entire market using index funds, you never do anything about it and you just keep buying. This is the buy, an old strategy that increases your odds of success over time. Stock picking is too difficult to be profitable and factor timing is impossible to do well. So, even if it seems like everything is pointing towards a certain outcome. There's a quote that's been attributed to many people. I'm not going to try to attribute it to any one person, but it's the idea that the market can remain irrational longer than you can remain solvent. So you trying to get in and out of the market based on what you think the valuation is reasonable or not isn't really instructive, because it can stay that way for a heck of a lot longer than you think and you might just lose your shirt in the process. So if you're not a passive index investor, there's another strategy. Many of my clients would be invested in this way. It's a bit more of a systematic way that doesn't look at just a pure market cap weighted index fund. There are ways to invest that actually lean into that value side of the market all the time. It's kind of always on value style of investing. Note that I didn't say you go entirely over the value all the time, because the risk of getting the timing of factors wrong is too high in my opinion. So the way that I do factor investing looks at the entire market and then tilts towards the parts that would have higher expected returns, including value stocks. So every day you can be positioned with a larger weighting in the stocks that have higher expected returns, instead of worrying about the valuation of stocks in general. That way, if the expensive stocks keep getting more expensive, you'll be in the game. But if the evidence on long term investing still holds true where value stocks outperform growth stocks over time then you're positioned in a good spot as well. This can be much more tricky to do for DIY investors, and so I recommend that, for people that are interested in this style of investing, you work with a professional that understands this approach. But the main takeaway here is that, even if the valuations appear to be at an all time high, the evidence says that that is not instructive on any sort of market timing strategy that you could employ reliably. I'm going to steal a line from one of the research pieces from Dimensional where they would say market valuations are analogous to sundials. They're fine as a rough gauge for the passage of time, but using one as an oven timer may leave you with an inedible casserole. I think that's a pretty good analogy there. By staying invested with a larger part of your portfolio in a value tilt, it increases your odds of success over a long enough period of time. It is not any sort of strategy for making money tomorrow, the next day, over the next year? It might be, but there's no short term predictability that can be reliably extracted from market valuations over the short term. So the main conclusions again. Maybe this is disappointing to hear, but staying in your seat with an approach that matches your timeline and your risk tolerance is the most reliable way to make money in the stock market, even when valuations are at all time highs, let alone the prices at all time highs. So if you have questions about this, I've got a lot of data, a few little pieces of research that I can extract for you. If anyone is interested, shoot me an email at podcast at evannewfieldcom, and I'd be glad to share some of those with you if you're interested. At all, podcasts aren't a great medium for sharing a lot of academic data, in my experience anyways, but hopefully this was interesting for you or something helped you understand investing from a valuation perspective. A lot of people ask these questions. I see it online all the time. I get emails from clients all the time, and so, putting some thoughts together on these two ideas of investing at all time highs from a price level, but also investing at all time highs from a valuation level. I thought was time well spent, so hopefully it was for you listening as well. I appreciate you listening so much. Thank you for subscribing and sharing with your friends. I look forward to sharing another episode with you next week. Thank you again for being here. And registered investment fund advisor. Mutual funds and ETFs are provided by Sterling Mutuals Inc.