The stock market is overvalued.

There are a number of ways to value individual stocks and the stock market as a whole, but I like the Shiller P/E ratio because it provides a single, easy to calculate number as a valuation metric. The Shiller P/E ratio is the price of the S&P 500 index divided by the average of the last 10 years of earnings for the companies in the S&P 500. Using 10 years of earnings rather than last year’s earnings smooths out yearly fluctuations and provides a more accurate valuation. 10 years is also long enough to cover all parts of the business cycle (from boom to bust) and thus isn’t whipsawed by short-term fluctuations in profits.

By that measure (and many others), the market is significantly overvalued. The Shiller P/E over the long-term (since 1882) has averaged 16.7. The current P/E is 27.1. That means the market is 62% overvalued.

What does that mean for future returns?

P/E ratios

A quick refresher for those of you who aren’t familiar with the P/E ratio. The P stands for Price, the E stands for Earnings.

Let’s say we have a stock that’s currently traded at $200/share and has $20/share in earnings. The P/E for this stock is $200/$10 = 20. If the price drops to $100 then the P/E ratio is $100/$10 = 10. If the price stays at $200 and the earnings from $10 to $20 then the P/E ratio is $200/$20 = 10.

“P/E Compression” refers to the effect that a change in the P/E ratio has on the return of stocks. If we predict that the P/E ratio will change from 20 to 10 over the next year then either the price must decrease or the earnings must decrease (or some combination of both).

Let’s say we take the stock mentioned above (price=$200, earnings = $10) and figure out how to get from a P/E of 20 to 10. In this case we’ll assume excellent earnings growth of 25% (going from $10 to $12.50). What would the price be? Well, since the formula is P/E = Price/Earnings, and we know the P/E is 10 and the Earnings are $12.5, we can solve for Price:

10 = Price / 12.5

Price = 10 * 12.5 = $125

This means the price of the stock dropped from $200 to $125, a 37.5% loss, even though the earnings grew by a massive 25% that year!

Having a higher than normal current P/E ratio acts as a drag on future returns and having a lower than normal P/E ratio acts as a tailwind for returns.

The Effects of P/E Compression

Now that we understand the effects of changes in the P/E ratio, we can calculate potential scenarios based on what we expect the value of the Shiller P/E ratio to be in the future. Since we are long-term investors let’s pick 10 years, as, again, that’s a long enough time to help smooth out some of the ups and downs of the business cycle.

The table below shows a few different scenarios, and how a change in the Shiller P/E would affect the returns on our stocks over the next 10 years.

10 year projections @ 10% yearly growth
Scenario Shiller P/E ratio in 10 years Annual Returns from change in P/E Assumed annual inflation Assumed growth in profits Dividends Yearly return Total 10 year return
Very optimistic – 50% above average 25.05 -0.78% 3% 10.00% 2% 8.22% 120.26%
Optimistic – 25% above average 20.88 -2.57% 3% 10.00% 2% 6.43% 86.42%
Reversion to mean 16.70 -4.73% 3% 10.00% 2% 4.27% 51.97%
Pessimistic – 25% below average 12.53 -7.42% 3% 10.00% 2% 1.58% 16.93%
Very pessimistic – 50% below average 8.35 -11.11% 3% 10.00% 2% -2.11% -19.17%

 

In the “Very Optimistic” row we are assuming that in 10 years the Shiller P/E for the S&P 500 will be 50% higher than its long-term average (but still slightly lower than today). As mentioned above, the long-term average for the Shiller P/E is 16.7, so a P/E 50% higher would be 25.05 (the number in the second column). In order for the Shiller P/E to drop from the current 27.1 to 25.05 over 10 years we’d need the Shiller P/E for the S&P 500 change by -.78%/year (the number in the third column). This is important, as that -.78% is a yearly drag on the performance of the market. If we then assume inflation at the long-term average (3%), a reasonably high growth in profits (10%/year), and dividends of 2%/year, we’d end up with a yearly return of 8.22%, or a total 10-year return of 120.26%. Hey, that’s not too bad, right? Yes, but remember…this was an incredibly rosy prediction, one where the Shiller P/E remains 50% higher than the average over the 100+ previous years AND profits are growing at 10%/year. That seems…unlikely. Even this best case scenario only ends up with market average returns over the next 10 years.

The more likely scenario is that we’ll revert to the average P/E ratio for the market. That would imply a Shiller P/E of 16.7 in 10 years. As we can see from the row titled “Reversion to mean”, having the P/E drop from the current 27.1 to 16.7 over 10 years will impose a drag of -4.73% PER YEAR for 10 years. If we then subtract the average long-term inflation rate of 3% and assume the same 10% per year growth in profits and 2%/year in dividends we see that we would have a 4.27% return per year. I don’t think anybody is investing in the stock market and hoping for 4.27%/year returns.

And what if things go poorly? Well, if the Shiller P/E drops to below its long-term average (say, 25% below the average) we’d see -1.42%/year returns and a total of -13.36% return after 10 years. We’d have LESS MONEY in 10 years than we have today.

And let’s not forget – this is assuming that profits are growing at healthy 10%/year. What if we assume a more mediocre growth rate of 5%/year?

 

10 year projections @ 5% yearly growth
Scenario Shiller P/E ratio in 10 years Annual Returns from change in P/E Assumed annual inflation Assumed growth in profits Dividends Yearly return Total 10 year return
Very optimistic – 50% above average 25.05 -0.78% 3% 5% 2% 3.22% 37.24%
Optimistic – 25% above average 20.88 -2.57% 3% 5% 2% 1.43% 15.21%
Reversion to mean 16.70 -4.73% 3% 5% 2% -0.73% -7.03%
Pessimistic – 25% below average 12.53 -7.42% 3% 5% 2% -3.42% -29.42%
Very pessimistic – 50% below average 8.35 -11.11% 3% 5% 2% -7.11% -52.15%

Now we have yearly returns of between 3.22% to -7.11%, with the most likely scenario being a miserable -0.73%/year. I hope nobody is investing in the market to have 7.03% less money in 10 years than they have today.

What if the change in the Shiller P/E takes place over 5 years instead of 10?

5 year projections @ 10% yearly growth
Scenario Shiller P/E ratio in 10 years Annual Returns from change in P/E Assumed annual inflation Assumed growth in profits Dividends Yearly return Total 5 year return
Very optimistic – 50% above average 25.05 -1.56% 3% 10% 2% 7.44% 43.16%
Optimistic – 25% above average 20.88 -5.08% 3% 10% 2% 3.92% 21.19%
Reversion to mean 16.70 -9.23% 3% 10% 2% -0.23% -1.14%
Pessimistic – 25% below average 12.53 -14.30% 3% 10% 2% -5.30% -23.82%
Very pessimistic – 50% below average 8.35 -20.98% 3% 10% 2% -11.98% -47.16%

And with 5% yearly growth

5 year projections @ 5% yearly growth
Scenario Shiller P/E ratio in 10 years Annual Returns from change in P/E Assumed annual inflation Assumed growth in profits Dividends Yearly return Total 5 year return
Very optimistic – 50% above average 25.05 -1.56% 3% 5% 2% 2.44% 12.81%
Optimistic – 25% above average 20.88 -5.08% 3% 5% 2% -1.08% -5.29%
Reversion to mean 16.70 -9.23% 3% 5% 2% -5.23% -23.55%
Pessimistic – 25% below average 12.53 -14.30% 3% 5% 2% -10.30% -41.92%
Very pessimistic – 50% below average 8.35 -20.98% 3% 5% 2% -16.98% -60.56%

Well, those numbers are just terrible, aren’t they? At 10% annual growth and the most likely situation of a reversion to the mean for the Shiller P/E we get a yearly return of -.23% for 5 years, and at 5% annual growth we get a yearly return of -5.23%. That’s just plain awful.

Conclusion

So what should investors do with this information?

First, we need to acknowledge that the stock market is a market of stocks. That is, there are lots of individual companies available for investment. At any given time some are overvalued, some are undervalued, and some are fairly valued. Just because the market as a whole is overvalued doesn’t mean that all stocks are overvalued. There are stocks available today that are either reasonably priced or have sufficient long-term growth prospects that they’ll be able to grow out of their current overvaluation.

However, when the market as a whole drops we tend to see just about every stock in the market drop. Not all stocks drop by the same amount, but in general overpriced stocks become more fairly valued, fairly valued stocks become cheap, and cheap stocks get ridiculously cheap.

Personally, I don’t see a lot of value in the market today, so other than automatic investments through my 401(k) and Loyal3 accounts, I’m making no new investments at these prices. All dividend and rental income will be added to my cash hoard, and I’ll be looking to deploy that cash when the market is cheaper and I see some compelling buys.

Some people will say that I’m trying to time the market. I don’t think that’s the case. There’s a difference between saying, “I think the market is going to go down tomorrow” and “I don’t see anything compelling to buy today”. I’m not necessarily waiting until the market drops before I deploy more capital. The market could stay at exactly the same price it’s at today, but if earning continue to grow then the valuation will become cheaper, and eventually I’ll find it cheap enough to buy into.

The bottom line – I prefer to invest my money when the odds are with me, and that means investing near or below the historical average for valuation.

What do you think? Are you deploying money today at these valuations? If so, what are you buying?