Is the Stock Market Over-Valued? Yes. Should you be worried? Not if you’re under 40.

Pundits have been arguing 3 very disparate views on the market. General consensus is that this year’s stock market returns will not equal last year’s 30% rally. The divergent perspectives are outlined below.

Will skepticism keep a healthy check on bull market overvaluation? This would seem to be a fair point. Bubbles only happen when most investors forget about risk. You cannot argue that we are in a bubble if everyone is yammering about the danger.

Is Buffett right? Are markets back to a fair valuation after years of cheap investment opportunities? Possibly. No one can argue that P/Es are cheap. Several famous value-oriented hedge fund managers -including Seth Klarman- returned money to clients over the past year.

Are markets 50-70% overvalued due to cheap global monetary policies such as the Yellen Put? Will the market stagnate as a result? Monetary policy should be concerning, especially for older investors with lower investment timelines. Stagnant markets can happen. You only have to go back to the 1970s to witness a largely flat decade.

Corporate Profit Margins at Historic Highs

One of the more interesting Bear arguments revolves around corporate profit margins.

Corporate After-Tax Profit as a % of GDP - Bears Love This Chart
Corporate After-Tax Profit as a % of GDP – Bears Love This Chart

Profit margins for U.S. corporations are at historically high levels. Bears think that a mean reversion is in order.

What the Bears fail to factor in is computerization. TI believe the Digital Revolution is a permanent economic upgrade 10 years ago, most of us did not have cell phones. Now we use them to efficiently navigate from point A to point B, to interact with co-workers, to pay our bills.

Perhaps the closest historical comparison we can make is to Great Britain during the Industrial Revolution. I found a very interesting paper detailing the effects of the Industrial Revolution on profit margins. Initially, wages were stagnant, inequality rose, while profit margins doubled. Returns on capital increased in proportion, as new technology investments paid off handsomely. A feedback loop ensued as corporate profits helped to balloon GDP. Sound familiar?

The next 50 years represented a high-water mark of prosperity for the British Empire. Wages eventually caught up, while profit margins stabilized at these new, higher levels after some rather minor mean reversion. Looking at the data from the industrial revolution, it seems clear that corporate profit margins could climb even higher, by as much as 1-6%.

Takeaways

Corporate profit margins, while high, are supported by fundamental improvements in efficiency thanks to the Digital Revolution.

Every market valuation argument has an implicit time-value attached. Hedge and mutual fund managers have to outperform not just every year, but every quarter. Thus market valuation outlooks tend to be skewed to the short-term. This makes some sense if you are trading into and out of companies every week.

However, even in this case we should be basing our estimates on individual stock valuations as well as the scope/scale of opportunity sets. So market valuation really shouldn’t matter much unless you run a macro-driven fund. The scope of opportunity sets has certainly shrunken, but I think there still may be pockets of undervaluation out there.

To anyone not pulling their money out of the market in 10 years, over/under-valuation debates are largely irrelevant. It shouldn’t matter to us what the market is doing in 10 years, or even 20, unless we plan to retire soon. If you ignore market valuation and use dollar-cost-averaging to invest in an ETF or more than 10 individual stock names for the long-term (20-50 years) you can count on the following:

  • Your dividends will compound the money you put in
  • The value of your portfolio will be much larger than the value of your original investment
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Author: secondhandstocks

The genesis for this blog stems from a Marine buddy and I came back from Afghanistan with more money than knowledge, and heedlessly tossed our hats into the stock market ring. A few months later, I remember discovering the classic book The Intelligent Investor by Graham and Dodd, and ravenously devouring my first introduction to value investing. That framework - with some generous additions by Seth Klarman, and Joel Greenblatt among others - guides my investment philosophy. I spent five years working in the intelligence field, both in the Marine Corps and then for a government agency after that. I speak Arabic and Pashto, have programming and analysis experience, and enjoy investing in technology companies as a hobby. I also spent a year on Wall Street working on a #1 Ranked Institutional Investor team, before deciding that that the Sell-Side was not for me.

3 thoughts on “Is the Stock Market Over-Valued? Yes. Should you be worried? Not if you’re under 40.”

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  2. Good day! This is my first comment here so I just wanted to give a quick
    shout out and tell you I truly enjoy reading through
    your blog posts. Can you recommend any other blogs/websites/forums
    that go over the same topics? Thanks!

    1. Thank you for the comments. Seeking Alpha isn’t a terrible place to start. You will see a lot of contrast in both quality and opinion. I like to read the Bull/Bear arguments while forming my own opinion. I also have a few blogs that I follow listed on the left-hand side of the page.

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