A recent article on the state of the financial markets began with the following lines: "Experts all seem to agree that the stock market is overvalued from a fundamental perspective. This conclusion can be reached based on almost any fundamental ratio."
The fundamental ratio most often cited in the price-to-earnings (PE) ratio. The current PE multiple sits at nearly 25. What that means is that an investor in the average stock in the S&P 500 is paying a hefty $25 for $1 of current earnings. To put that in perspective, the median historical PE multiple is 14.7. When viewed in isolation, the stock market does appear overvalued and by as much as 70%
But, it is fallacious to simply determine that the stock market is overvalued based simply upon that one widely-cited metric. One should look at investment alternatives to the stock market when trying to determine if stocks are overvalued. This is exactly where the analysis gets murky.
The most common alternative to buying stocks is bonds. And, with historically low interest rates, the expected return on bonds is downright dismal. The 10-year US government bond is now yielding 2.19%. What this means is that an investor purchasing the 10-year bond and holding it to maturity, will earn 2.19% annually on that investment.
To put the bond return in perspective, the current dividend yield on the S&P 500 is 1.89%. This means that if S&P 500 stocks suddenly stopped increasing dividends and the stock market sold at the same level ten years from now that it sells at today -- neither likely -- the stock investor would underperform the bond investor by only 0.3% (30 basis points) annually.
We all know that, over the long term, the stock market tends to rise and companies tend to increase dividends annually. The average annual return on the S&P 500 is approximately 10% annually. And, the average historical S&P 500 dividend growth rate is 6%.
If my investment time horizon is ten years, would I rather lock in a return of 2.19% or bet that my return from investing in a broadly diversified stock index will exceed that? I know which side of that bet I will take. Now, if my time horizon is less than ten years, my conclusion might change.
Of course, some will argue that selling stocks and raising cash is prudent because once markets drop, one can step in and buy stocks on sale. To that I would respond with the old Wall Street adage that "nobody rings a bell at the top or bottom of the market." While you certainly can't go broke from holding cash, you stand to suffer a huge opportunity loss by not being invested in the stock market for long periods of time. Just ask investors who bailed on the markets during the financial crisis.
The line about everyone agreeing that the market is overvalued reminds me of the quote by that famous baseball philosopher Yogi Berra who once said about a restaurant "Nobody goes there anymore. It's too crowded."