The International Monetary Fund (IMF) recently warned that stock market valuations—gauges comparing equity prices to measures of the value of their underlying businesses—are “stretched,” especially in the U.S. and Japan. The IMF contends this increases the risk of downturns in financial markets and the economy.[i] But research from Ken Fisher (Trades, Portfolio)—Founder and Executive Chairman of Fisher Investments—shows valuations don’t reliably foretell market direction. Their signals are often just noise. Basing investment decisions on these measures could lead you to buy and sell at inopportune times.
Over the years, we have found many commentators citing valuation levels as reason to be bullish or bearish. Ken Fisher (Trades, Portfolio) is often asked in interviews about them. Recent headlines like “Market Remains Overvalued,”[ii] “Five Tech Stocks That Are Overvalued at the Current Price”[iii] and “7 Reasons Stocks May Be Drastically Overvalued” are commonplace, and all urge caution because of valuations.[iv] Such articles cite a number of metrics to support their claims. The most common is the price-earnings ratio (P/E), which compares share prices (or index price levels) to the earnings produced by the company (or the companies in the index).
Another popular metric, the price-book ratio, compares share prices to a company’s book value (total assets minus total liabilities). And finally, there is the price-sales ratio (PSR)—which Ken Fisher (Trades, Portfolio) popularized in the early 1980s—comparing share prices to the company’s sales.
On the surface, the argument for avoiding equities when valuations appear high seems logical. After all, the old saying is, “buy low and sell high.” A lofty valuation seemingly implies prices are already high. In its recent Global Financial Stability Report, the IMF gives credence to these notions, contending that stock valuations are high in the U.S. and Japan, which it attributed to low interest rates. This is a nod to the so-called “Great Rotation” theory, which many pundits have talked about for years. This theory argues low interest rates mean low bond returns, driving investors to seek greater potential returns in more volatile assets, like stocks. The IMF contends this has driven stock valuations higher, increasing risk—especially now, with some central banks like the Fed and ECB cutting short-term interest rates.
But after extensive research, we have found P/Es and other valuation metrics have little predictive power for equity returns. In his 2012 book "The Only Three Questions That Still Count," Ken Fisher (Trades, Portfolio) looked at annual U.S. equity returns from 1872 – 2010, separating the years into “high,” “low,” and “normal” categories based on the market’s P/E on Jan. 1. In 20 of those calendar years, the U.S. market fell more than 10%. In 16 of those 20 years, the market P/E started out in the “normal” or “low” categories—the opposite of what conventional wisdom would assume.[v] When P/Es started the year at the “high” end of the range, the market declined that year about 30% of the time. When P/Es started in the “low” and “normal” ranges, the market declined about 28% of those years—little different.[vi]
Ken Fisher (Trades, Portfolio)’s research found other valuation metrics, like the price-book ratio, also did not serve as consistent predictors of future stock returns. Even the PSR, which Ken Fisher (Trades, Portfolio) once believed worked by finding overlooked stocks with temporary, profit-impairing problems, seems to no longer work well.
While it might seem counterintuitive that valuation doesn’t impact future returns, we think a closer look reveals why this is so. Consider P/Es: They are composed of two variables—price and earnings. P/Es rise when share prices go up more quickly than earnings, indicating increases in investor sentiment. But if earnings decline more quickly than prices—common in recessions—P/Es can jump even as equity prices fall to very attractive levels.
Moreover, nearly every financial professional’s training includes primers on P/Es and other well-known valuation metrics. Ken Fisher thinks markets are mostly efficient—meaning prices reflect well-known information. So many investors are aware of these metrics that trading on them offers no advantage, in our view. That is behind the PSR’s declining utility—as it grew in popularity, its utility declined.
As for the IMF’s theory that low interest rates have overheated stock markets, the data indicate otherwise. From the start of 2017 through October of this year, U.S. investors pulled a net $37.6 billion from equity mutual and exchange-traded funds.[vii] Over the same stretch, they injected a net $844.5 billion into fixed interest funds.[viii] This isn’t just an American phenomenon. Since the start of 2016, British investors have moved a net 2.8 billion pounds out of U.K. and overseas stock funds.[ix] Over the same period, they have put a net of 18.6 billion pounds into corresponding bond funds.[x] All this hardly seems indicative of a “Great Rotation” into stocks. Beyond individual investors, it isn’t likely institutions rotated either. In our experience, many institutional investors—large groups like pension funds and university endowments, which make up a sizeable portion of the market—employ fixed asset allocations. Short-term interest rate movements are unlikely to sway them.
While Ken Fisher (Trades, Portfolio) has found that P/Es and other valuation metrics are not predictive of future stocks market returns, we think they can be useful tools in the proper context. In particular, we have found rapidly rising valuations can be a sign of euphoric sentiment, which generally portends trouble for stocks. While today’s valuations may be higher than average, they are not rapidly rising, and stock market and economic confidence is muted in the U.S. and across much of the world. For the four weeks ending Dec. 12, the American Association of Individual Investors’ weekly sentiment survey found an average of 34.3% of respondents expected stocks to rise in the coming six months.[xi] That’s below the long-term average of 38.1%.[xii] Overseas, U.K. economic sentiment fell in September to its lowest level since 2012.[xiii] It is only slightly higher today. In the eurozone, the same measure sunk in October to levels not seen since 2015, before inching higher in November.[xiv]
With that dour backdrop in mind, recent concerns about valuations are actually bullish, in Ken Fisher (Trades, Portfolio)’s view. Ironically, the fears show sentiment has not reached the overheated levels that can derail bull markets, which bodes well for the continuation of stocks’ upward climb.
Investing in stock markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance is no guarantee of future returns. International currency fluctuations may result in a higher or lower investment return. This document constitutes the general views of Fisher Investments and should not be regarded as personalized investment or tax advice or as a representation of its performance or that of its clients. No assurances are made that Fisher Investments will continue to hold these views, which may change at any time based on new information, analysis or reconsideration. In addition, no assurances are made regarding the accuracy of any forecast made herein. Not all past forecasts have been, nor future forecasts will be, as accurate as any contained herein.
[i] International Monetary Fund, “Global Financial Stability Report 2019,” October 2019.
[ii] “Market Remains Overvalued,” Jill Mislinski, Advisor Perspectives, 10/2/2019.
https://www.advisorperspectives.com/dshort/updates/2019/10/02/market-remains-overvalued
[iii] “Five Tech Stocks That Are Overvalued at the Current Price,” Aditya Raghunath, Market Realist, 9/5/2019.
https://articles2.marketrealist.com/2019/09/five-tech-stocks-that-are-overvalued-at-the-current-price/
[iv] “7 Reasons Stocks May Be Drastically Overvalued,” Mark Kolakowski, Investopedia, 6/25/2019.
https://www.investopedia.com/6-reasons-stocks-may-be-drastically-overvalued-4579884
[v] The Only Three Questions That Still Count, Ken Fisher (Trades, Portfolio), John Wiley & Sons, Inc., 2012.
[vi] Ibid.
[vii] Source: Investment Company Institute, as of 12/12/2019. Long-Term Mutual Fund and Exchange-Traded Fund Flows, 1/1/2017 – 10/31/2019.
http://www.ici.org/info/combined_flows_data_2019.xls
[viii] Ibid.
[ix] Source: The Investment Association, as of 10/24/2019. Retail sales for UK and recognized overseas funds 2016-2018.
https://www.theia.org/industry-data/fund-statistics/retail-sales/20
[x] Ibid.
[xi] Source: FactSet, as of 12/18/2019. American Association of Individual Investors Sentiment Survey, average percent bullish from 11/22/2019 – 12/13/2019.
[xii] Source: FactSet, as of 12/18/2019. American Association of Individual Investors Sentiment Survey, average percent bullish from 7/24/1987 – 12/13/2019.
[xiii] Source: Eurostat, as of 12/12/2019. Economic Sentiment Indicator, monthly data, seasonally adjusted.
[xiv] Ibid.
