Are Markets Really Overvalued?

Wesley Gray |

Recently, there has been a lot of talk of markets being overvalued. So, naturally the asset management team at Alpha Architect wanted to look into this and see if there is any solid evidence to support the claim. Below, finance professor and team leader at Alpha Architect Wesley Gray examines their findings.

 

For this study, we looked at the high level summary as of February 28, 2015 from 1/1990 to 2/2015:
 

Alpha_Architect_Market_Values_3_19.jpg


By any reasonable standard, these metrics aren't screaming "overvalued:" P/E, P/B, TEV/EBITDA, and TEV/GP are all in the 50-75 percentile, with TEV/FCF actually in the 2 to 25 percentile.

In fact, adjusted for the current interest rate environment (much lower than it was in the past), the argument that the market is extremely overvalued is actually quite far-fetched. TO see for yourself, check out these results in the graphs below:

Visual Valuations

P/E

Price-to-Earnings

pe

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

 

P/B

Price-to-Book

pb

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

 

TEV/EBITDA

Total Enterprise Value-to-Earnings Before Interest Taxes Depreciation and Amortization

tev

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

 

TEV/FCF

Total Enterprise Value-to-Free Cash Flow

tevfcf

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

 

 TEV/GP

Total Enterprise Value-to-Gross Profits

gp

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

 

Thoughts on the Results

Our quick and dirty analysis suggests that the market is not extremely overvalued. So how come this doesn't jibe with so many results coming out of the media?

The answer has to do with a framing effect. Many "markets-are-crazy-expensive" stories look at the history of markets going back to before 1900 (typically using the Shiller CAPE data). Our team at Alpha Architect just did our own version of this story a few weeks ago. Sure enough, based on CAPE ratios, the market is in the 94 percentile--pretty high!

By contrast, the data for our metrics only go back to 1990--not 1890!

When current valuations are positioned against valuations over the past 25 years, things look "normal-ish." Yet, when current valuations are positioned against valuations from pre-1990, they may appear to be wildly overvalued.

What to Make of this "Framing" Effect

On one hand, a longer history may give us more insight into valuations over time. Yet, on the other hand, market conditions 100+ years ago may be different than they are today.

How useful is it to compare valuations today, versus valuations that prevailed at other points in history? The dynamics associated with longer run regimes may be in place. For example, in the beginning of the Twentieth Century, the US market was a comparatively young emerging market economy, and it wasn't obvious that it would emerge as the dominant economy for the next 100 years. In these early days, the US market may have been priced more cheaply based on its embedded emerging market risk. For a more modern example, consider valuations on the BRIC and the PIGS versus the developed market countries. Emerging market countries often have more risk, so on average, their valuation metrics are much lower than those of developed market countries.

Also, 25 years is a decent length of time. Maybe this sample from the recent past better represents current conditions and risks associated with investing in US markets today, versus a period wherein the global and US economies looked and behaved in vastly different ways.

Again, when you are computing average valuations, if you include long stretches when US markets were cheap for reasons unrelated to important aspects of modern world economies, you may get an average that is flawed in some ways. Then again, this sounds a bit like the "new valuation paradigm" thinking that prevailed during the dotcom boom when valuations went crazy. Regardless, our analysis above will hopefully enhance the discussion around market valuations. The current discussion is very black and white--commentators are calling for an epic and inevitable crash, or they are calling for Dow 100,000. Hopefully, we open the debate and generate more nuanced views on market valuations. 

 

For more market anaylsis from Wesley R. Gray, check out his blog at Alpha Architects here.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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