Whether experienced or inexperienced, investors are always wondering and worrying about when to time their stock purchases. Purchasing stocks at the wrong times over the course of the equity cycle can leave you with poor returns, or even worse, huge losses.
So is now a good time to invest in the market (the “market” being defined as the Standard & Poor's 500). Currently, the market is trading at an all-time high with most stocks appearing expensive. That said, the economic environment remains positive with low interest rates, minimal inflationary pressures, low unemployment and production capacity returning to normal levels. This is a dilemma for new and experienced investors alike.
Nobody wants to buy into the index near a possible peak if it’s going to crash 20% over the next year. On the other hand, the stock market might just continue to go up for the next few years. And no one wants to miss out on those potential gains either. If you look around on the internet, you’ll see all sorts of articles as far back as 2013 telling investors that it is time pull out of the stock market as valuations post-recession advanced too quickly. But here we are, and the S&P 500 index has gained more than 1,000 points since that time. We would be a lot poorer had we listened to that advice.
In all honesty, we are nervous about the stock market. Some key macro indicators we like to follow suggest staying the course: others are screaming “get out.” You can’t deny that the market has been on a tear for years and, history suggests, it’s just a matter of time and we will see some reversal. The issue becomes what will be the catalyst – like a trade war or actual war –Â that will cause that reversal to happen.
At times like these, we like to think about how Graham would have approached the current market environment. Would he have considered investing in the market to be the right course of action?
Valuation Approach
Below we discuss Benjamin Graham’s once well-known, but long forgotten, approach to valuing the stock market. As per Graham’s traditional valuation discipline, Graham was concerned about the fundamentals inherent in the broad earnings generation power of the economy as well as the inflationary, employment, and production levels of the economy as reflected in broad market interest rates. Graham advocated using this approach to passively enter the market at near market troughs and exit the market at near-market peaks, without staying too long out of the market or missing any major market moves.
Graham’s valuation approach involved estimating a central value or fair value for the market by capitalizing the average EPS over the previous 10 years by an “equilibrium” multiplier. This equilibrium multiplier was equal to 1 divided by k-times the yield on AAA-rated corporate bonds. A summary of the valuation formula is provided below:
Central value = (10-year average EPS) x (1/(k x AAA-Corporate Bond Yield))
Graham then established lower and upper price bounds equal to 80% and 120% of the central value estimate, respectively, and considered this a fair value range for the index.
In Graham’s original model k was equal to 2. That is, he capitalized earnings at 1 divided by twice the AAA-rated corporate bond yield. While that might have worked in the 1940s and 1950s, capitalizing at k=2 in today's fast-moving market environment would not provide satisfactory results. To determine the value of "k" for our model results below, we relied on an optimization procedure that varied the parameter value one by one until it converged on a “best-fitting” central value.
Graham explained that when the market price line trended near or exceeded the upper price bound (that is, 120% of its central value), then investors could expect the market to fall or move sideways until it was back within the central value range. At these times, investors should consider reducing their positions or taking some profits. Similarly, Graham explained that when the market price line trended near or fell below the lower price bound (that is, 80% of its central value), then investors could expect the market to rise until it was back within the central value range. At these times, value investors should consider growing their positions.
Model results
The figure below presents model results going back to 2000, at the start of the IT bubble. The red line represents the index value on the S&P 500 while the blue line represents the model-derived central value. The black area reflects the fair value range for the index.
Figure: S&P 500 (red), central value (blue), fair value range (black)
As can be seen, the model signaled significant overvaluation leading up to the bursting of the tech bubble in 2000 to 2001. It happened that the model signaled fair valuation from 2003 and 2006 but trended at the upper end of the valuation range with occasional breaches. The model successfully signaled overvaluation in 2007. Had an investor been guided by the model, he/she might have sold out in 2007 and avoided incurring massive losses in 2008. Also, in 2009, the model signaled a strong contrarian buy signal. The model signaled undervaluation again in 2011. The model signaled fair valuation in 2013 and 2014 and flagged another purchase opportunity in early 2016.
What is the model currently signaling?
Earnings on the S&P 500 over the last 10 years have averaged $76.67 per share; AAA-rated corporate bonds are yielding 3.6%; and at an optimized value of k=0.8, the model suggests a fair value for the index of 2,656. This is 11% higher than the current index value of 2,399. The 80%-120% valuation range for the index spans from 2,125 to 3,187. This means that at the current valuation level, the S&P 500 is approximately fairly valued. Investors should expect to earn normal historical returns on the index until such time as we see a notable change in corporate earnings or broad market interest rates.
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