Are stocks overvalued after last years surge ?
Are stocks overvalued after last years surge?
One of the thorniest topics in investment is valuations. Some claim that stock markets, after last year’s rally, are as high as they are likely to get. Any further rise in stocks from here will, therefore, need to be justified by an increase in company earnings.
This matters because it is generally accepted that the best indicator of future returns from an investment is the price you pay at the outset. Buy when valuations are low and the odds favour a decent outcome. Buy when prices are stretched and you may be half way to a disappointing result.
The reason why valuations are a thorny topic is that there is little agreement on them. The best brains in investment are unable to agree as to which measure to use or how to calculate it. As a consequence, one person’s reasonably valued market is another’s bubble waiting to burst.
Most analysts focus on one of the simpler measures, the ratio of share prices to expected earnings in the next year – the so-called price-to-earnings ratio. On that basis, Goldman Sachs said in a recent report that US shares are trading at nearly 16 times forecast earnings, which compares with an average multiple over the past 35 years of 13. Since 1976, this ratio has only exceeded 17 about 5% of the time. In other words, for the US market to become much more highly valued would be unusual.
One counter argument is that in an environment of artificially suppressed interest rates, valuation multiples can be expected to be higher than average. That is because the present value of future earnings is greater to an investor today, if it is calculated using a lower interest rate.
Valuation multiples may drop towards their longer-term average eventually but knowing when they will do so is hard to judge. On many valuation measures, it was possible to argue this time last year that stocks were overvalued – and many people did just that before watching the US S&P rally 30% and Australia’s S&P/ASX 200 Accumulation Index surge 20.2% over 2013.
Deciding when valuations have gone too far is an art, not a science. It is as much to do with sentiment as mathematics. And sentiment feels a lot less optimistic than these increases might suggest. The global financial crisis has left people more pessimistic compared with during those heady pre-2007 days.
Anyway, we are about to get a solid test of valuations. Companies the world over, including in Australia, are about to report on how they went in the latter part of 2013. Chief executives will tell us how they expect their businesses to perform in coming years. In a few weeks or so, we’ll have a much better sense of whether stocks are fairly priced or not.
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