How Low Can We Go?
In our first Personal Finance issue of 2016 we showed that, according to several experts’ measures, the market was pricey (“Just How Expensive Is This Market?”). So far this year the market is down a tumultuous 6.4%, as measured by the Standard & Poor’s 500 stock index. Has the decline brought us closer to what those experts would be considered is a reasonable valuation?
Not even close. Especially as problems such as a weakening China, the decline of energy and global economic weakness continue to be drags on the United States, we have plenty of factors that could cause us to fall more. All the more reason investors need to have a good strategy in place, such as our IDEAL system.
One of the measures we examined in that story was the CAPE ratio, the invention of Princeton University professor (and Nobel Prize laureate) Robert Shiller. Shiller’s is noted for many things, but among his top claims to fame is calling financial bubbles, including the real estate bubble behind the 2008 financial meltdown.
In early January of this year the CAPE ratio stood at 26.5, significantly higher than the historical mean of the ratio, 16.7. That showed the market was overvalued at least as much as it was in 2007 before the crash.
At the time of this writing, the CAPE ratio has dropped to about 24, still above the 16.7 mean. So, according to CAPE, the market is still inflated.
Shiller’s CAPE ratio uses the inflation-adjusted price level of the Standard & Poor’s 500 as the numerator, and the 10-year moving average of inflation-adjusted earnings as the denominator. By showing more than an earnings snapshot, he says it provides a more accurate measure than the more common measure that compares the trailing 12-month stock price to company earnings.
In that article we also discussed the Buffett Indicator, from legendary investor Warren Buffett. This is the ratio of market capitalization to GDP. It dropped from 129.8% in Q3 2015 to 114.3% in Q4 2015, and it remains about that level today. This measure also indicates a move towards a reasonable valuation, but the market is still pricey given that 100% is the baseline.
So judging by these measures the market is still overvalued, and we shouldn’t be surprised with further declines.
However, just because the market may drop significantly more doesn’t mean all stocks will fall equally, of course. The market now is inflated by a number of over-priced growth stocks that aren’t growing much anymore, and will be particularly hurt by rising interest rates and weak international demand. But other stocks should not only hold up well, they should continue to appreciate.
As 2016 unfolds we’re going to continue seeing the emergence of the two-tier market that Personal Finance Chief Investment Strategist Jim Pearce had predicted. Those overvalued companies are going to get a beat down and drag the market down with them, while our Personal Finance Growth Portfolio should weather the turmoil much better.
Further, this environment also presents an excellent opportunity to but some of the Personal Finance recommendations at discounted prices. So keep an eye on the price levels of stocks with high IDEAL scores and put the cash portion of your portfolio to good use while prices dip. We’ll advise you when particularly juicy bargains appear.
Also, Jim will review many of the strongest stocks in the Growth Portfolio in the next issue of Personal Finance.