The US stock market seems to be testing new highs by the day. As of this writing, the S&P 500 has delivered a total return of 27.5% in 2013. With past financial bubbles still fresh in investors’ minds, there is more than a little anxiety that the market has gotten ahead of itself.
To be sure, there are rare occasions when the market gives clear signals that it is either massively undervalued or overvalued. In late 1999, experienced investors recognized that stock valuations had become completely disconnected from reality—especially in the technology sector—and it made sense to raise cash. In late 2008 and early 2009, it was fairly obvious that most stocks were very cheap in any scenario other than a complete meltdown of the global economy. The median stock in Morningstar’s coverage universe was trading at an incredible 45% discount to our fair value estimate at that time, and it made sense to double down on equities.
However, these are more the exceptions than the rule. The vast majority of the time—including now—the market’s valuation is simply too uncertain to make drastic portfolio changes in response. Some investors believe that we are still in the early stages of economic recovery, with significant pent-up demand and underutilized capacity that will drive robust economic and earnings growth in the coming years. Other investors argue that profit margins are at unsustainable highs, P/E ratios are inflated if you use a longer-term average of earnings, and the market is only being held afloat by the Federal Reserve’s exceedingly loose monetary policy.
Is the Market Overvalued?
As of this writing, the median stock in Morningstar’s coverage universe is trading at a modest 2% premium to our fair value estimate. This is a bottom-up measure based on our analysis of the potential of individual businesses to generate future cash flows. Despite the market’s steep ascent in 2013, this metric actually hasn’t moved much since the beginning of the year, when the median stock was trading right at fair value.
This illustrates a key point: Intrinsic value is a moving target. Companies’ intrinsic values tend to increase over time as they collect cash flows, grow their earnings, and raise their dividends.
A reasonable total return is already incorporated in our fair value estimates when we discount future cash flows. While there will almost certainly be times in the future that the market is trading below fair value, there’s no guarantee that stock prices will be lower when that happens, because fair value itself will most likely be higher. This is what Buffett means when he says that investors are in a game that is heavily stacked in their favour.
From a top-down perspective, the market also looks about fairly valued. The S&P 500 (at a level of 1,776) is trading at 17.4 times trailing-12-month operating earnings per share, which compares to a median of 17.7 times over the past 25 years. Many value investors prefer the so-called Shiller price/earnings ratio, which uses a 10-year historical average of earnings in the denominator, adjusting for inflation. By that measure, the S&P’s cyclically adjusted P/E ratio is 24.8, compared with a median of around 23.1 over the past 25 years. In both cases, valuations in the past 25 years have generally been higher than they were in the prior century, although I suspect there are some very legitimate reasons for this, including low and stable inflation, improved corporate transparency and governance, and more widespread investor participation in the stock market.
