Are Stocks Overvalued?

Recently, I got the following e-mail from a reader:

"I was amazed to read in your March 15 article that there is little fundamental reason that the market can't go lower. It is up 1,000 points since you made that famous statement. Too bad so many subscribers have lost money this week listening to you." --D.S.

D.S. is referring to an article I wrote in the March edition of Morningstar StockInvestor titled "Are Stocks Cheap Yet?" In it, I made the point that although stocks have fallen precipitously over the past three years, they still didn't look undervalued enough to get excited about, and there's certainly no compelling reason why they must be done going down. When that article was published, the Dow stood at 7,900, about 500 points lower than it is today.

Not a Market Call
Of course, trying to divine the direction of the stock market over any short-term period is a sucker's game. As Warren Buffett says, market predictions speak volumes about the predictor, but they tell you absolutely nothing about where the market is really heading. So, with all due respect to D.S., I'll reiterate that I'm not saying stocks are necessarily going to resume their downward trajectory tomorrow, or the next day, or the next week or month.

That said, I believe that stock prices are presently stuck in a sort of valuation limbo--they aren't egregiously overvalued, but they aren't cheap either, at least not when compared with estimates of their future cash flows. In order for a bull market to begin again, stocks need to start from a much lower valuation trough than we have today.

It's impossible, however, to know how the market will reach that valuation trough. Conceivably, it could happen in one big crash, with stocks falling 10% or 20% in one day like they did on Oct. 19, 1987. That seems pretty unlikely to me, though. Alternatively, it could happen over a multiyear period, with stock prices stagnating while earnings and cash flows (and interest rates) rise.

This second scenario actually seems fairly likely. After all, the S&P 500 is at 891 today--about the same level as in mid-1997. That means prices have essentially been "flat" for six years and counting (though admittedly it's been an incredibly bumpy ride over that time period).

Is six years a long enough period to conclude that it's time for stocks to start going up again? Not necessarily. During the 25-year period from October 1929 to the end of 1954, the prices of the stocks in the Dow Jones Industrial Average rose 0% annually, on average (though total returns during this period were positive because of the high dividend yields on stocks). From 1966 to 1983--17 years--the Dow also rose 0% annually, on average. (Again, the total returns on stocks during this stretch were positive because of high dividend yields.) And in Japan, stock prices have been flat, on average, for the last 20 years and counting.

So I can't in good conscience argue that a new bull market is on the immediate horizon no matter how much I'd love that to be the case (and believe me, I would). We had a once-in-a-lifetime string of positive economic news and world stability during the 1990s. This created conditions that were perfect for stocks: falling interest rates, lower perceived risk, and rising earnings. And at the beginning of that decade, there was a lot more headroom--the P/E ratio of the S&P 500 was about half of what it is currently, and the dividend yield was much higher than the paltry 1.8% it is today.

In my opinion, investors should be prepared for weak equity performance until valuations reach the point where stocks are downright bargains. And we're not there yet. As evidence, consider that the average price/fair value estimate ratio of all the stocks Morningstar covers is currently about 0.99. In other words, stocks are about 1% undervalued, on average, according to Morningstar's analyst staff--not exactly a bargain-hunter's paradise. By contrast, the ratio got as low as 0.8 last October, meaning our staff thought stocks were about 20% undervalued.

Why Not Sell Everything?
So should you sell all your stocks and get out of the market? No, for (at least) three reasons:

1. If I were to pound the table and declare, "Sell your stocks now and buy them back later!" I'd have to be right twice: When to sell (now) and when to get back in (who knows?). Even if I was right on the first prediction, being wrong on the second prediction would render the first one worthless. And trying to perfectly time where the market is headed is akin to playing blackjack: 50/50 odds at best. As a rule, I recommend investors avoid betting money on games where the odds aren't clearly in their favor. 
    
2. Where else will you put your money? Assuming stocks are roughly fairly valued, the odds are high that the long-term returns of stocks should be better than those of fixed-income investments. (By long-term, I mean five to 10 years, minimum.) Ten-year treasuries pay about 4% right now, but if you buy treasuries, your total returns will be lower than 4% if interest rates go higher. And as I see it, the odds are greater than 50/50 that rates will move up from here, not down. If you try to juice your returns by buying high-yield bonds, you're making a bet on corporate earnings. But if corporate earnings do well, so should stocks.
    
3. Market bottoms happen when nearly everyone is predicting that stocks will go down further. By the time most people realize things are turning up, the market has usually jumped well off its lows. And if you've sold all your stocks, you're almost guaranteed to miss the sweet spot of a market rebound--the very beginning, when prices rise quickly.

In the Long Term, Stocks Must Rise
There's only one thing we do know with certainty: Over time, stocks must rise. But since there's no way to be sure about the timing, all you can do is buy great companies at cheap prices and hold them. You'll certainly sleep a lot better at night not worrying whether tomorrow is the day to jump back into the market or not. That kind of daily pressure is counterproductive, and it can drive you crazy.

Finding great companies isn't that difficult. We publish a list of 50 companies with wide economic moats each month in Morningstar StockInvestor. Some of these include  Wal-Mart (WMT),  Pfizer (PFE),  First Data ,  Home Depot (HD), and  Berkshire Hathaway (BRK.B).

Going Against the Grain
The hard part, of course, is being disciplined enough to wait for these great companies to become true bargains. That's the mistake everyone made during the latter stages of the Great Bull Market. The vast majority of investors would rather do what everyone else is doing, taking hollow comfort in the knowledge that if they're wrong, at least everyone else was, too. In my opinion, developing the discipline to wait for a better price is the most difficult aspect of investing. It requires saint-like patience and the strength of conviction to buy while everyone else seems to be selling.

Of course, going against the grain can be very uncomfortable, and few people will voluntarily subject themselves to discomfort without proof that they'll be better off in the long run by doing so. But there is no proof in the stock market. Decisions about the future must be based on imperfect information and rough probabilities. It's not for everyone.