Is the stock market very expensive?

Is the stock market very expensive?

“Buy good companies, don’t overpay, and don’t do anything.” (Fundsmith motto).

Lately, both clients and friends ask me quite often if the bag is too expensive. In the past week, quintet published an interesting report on the matter with which I felt very identified. So I will try to summarize it and extract its main graphs.

It is true that commonly used valuation measures, such as the price-earnings ratio (P/E = listing price/earnings per share; the lower, the cheaper the stock), suggest that stock markets are somewhat expensive in historical terms. There are significant differences between regions, but most bags look expensive from that perspective:

In building portfolios, investors weigh the relative attractiveness of different asset classes. As interest rates fall, bond prices rise and become relatively less attractive. Investors reallocate money to equities, which also pushes their price up until the relative attractiveness becomes more balanced again.

As we can see, US stocks are quite cheap compared to US Treasury bonds. ratio earnings yield (earnings per share / listing price) is higher than the 10-year bond yield. However, this is a very simplified measure and it is not a good idea to base investment decisions on this alone:

The second reason why very low interest rates should translate into higher stock valuations is the importance of the discount rate.

A share gives its owner a claim on the company’s future profits. To assess a reasonable price, the investor needs to estimate the present value of the company’s expected earnings. To estimate that present value, we discount the expected future benefits by the anticipated interest rate. In this simplified model, a company’s fair price would rise for two reasons: 1) higher expected earnings growth, or 2) a lower discount rate.

As this graph shows, an interest rate that is significantly lower than in the past (1% vs. 4%) greatly increases the fair value of the stock. The effect is more pronounced the higher the expected earnings growth (as more earnings are generated in the future, which is when the discount rate is most important), which is mainly the case with the style growth:

When comparing current valuations with those of the past, we must make sure that we are comparing pears with pears. Today’s market is not the same as that of yesteryear.

During the first decade of this century, the combined weight of technology and telecommunications in the US was around 20%. Since then, it has doubled to 40%. Meanwhile, the weight of the financial sector and raw materials has been significantly reduced.

It is very important to keep this in mind because different sectors tend to trade at different average valuations. The companies growth, which are expected to deliver superior earnings growth, trade at a higher P/E than the broader market. Investors are often willing to pay higher (relative) prices for fast-growing and innovative companies than for companies in the later stages of the product life cycle or in saturated markets.

This graph shows that, in the United States and assuming current sector weights, the average PER would have been 1.2 times higher since 1995:

Attractive returns can be achieved by increasing company valuations or earnings (or a combination of both). Looking at the last five US recessions, we can divide the subsequent rally in the stock market into two phases:

– First: while corporate profits decline and the economy remains in recession, investors anticipate change. Stock prices start to rise rapidly driving up the P/E.

– Second: the growth of corporate profits becomes real and becomes the main driver. Stock prices continue to rise, while P/E starts to decline (as earnings grow faster than stock prices).

There are two conclusions. First, it is common to see high valuations after the initial stage of recovery, which is where we are in the current cycle. Second, for stocks to generate attractive returns, ever-increasing valuations are not necessary. In fact, the global P/E has not changed since the beginning of the year, while world stocks are up more than 15%.

The shares are not too expensive. Current valuations are not a reason to flee the stock market. Taking profits and waiting for a more attractive entry point may sound interesting, but historically valuation alone has not been a very helpful guide to investment decisions over the next 6-12 months:

The macroeconomic backdrop remains a tailwind for equity markets. If you are hesitating whether to buy now or wait, charles schwab He usually says: “Any time is a good time to invest if you want to get ahead in life and improve your wealth.”


Adminartua

Leave a Reply

Your email address will not be published.