Perhaps this warning comes a bit late for some investors, but please fasten your seatbelt when the stock market is in motion and emotions are running high.
As a result of the uncertainty tied to the coronavirus disease 2019 (COVID-19) pandemic, the benchmark S&P 500 (^GSPC 1.02%) initially plunged into bear market territory in a shade over three weeks during late February and into March. At its peak, the widely followed index shed 34% of its value in just 33 calendar days. Both the initial bear market decline, as well as the 30% drop, mark the swiftest wipeouts in stock market history from a recent high.
But just as fast as things went south for equities, they've seemed to perk up. Over the past 11 weeks, the broader market has been unstoppable. The S&P 500 has regained well over 40% from its lows, and equities look to have firmly established a new bull market.
There's just one problem, though: Stocks are historically expensive.
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Equities have only been this expensive five times in 150 years
One of the most common ways for investors to measure value is by using the price-to-earnings ratio. Of course, having historical price-to-earnings data can be considerably more beneficial. That's where the Shiller price-to-earnings ratio come into play.
The Shiller P/E ratio is based on average inflation-adjusted earnings from the previous 10 years. As of Monday's close, June 8, 2020, the Shiller P/E crested 30 for only the fifth time in 150 years. For those interested, the average Shiller P/E over the past 150 years is about 16.7.
When the Shiller P/E ratio has previously hit at least 30, here's what happened:
- 1929: Following Black Tuesday, the stock market would go onto lose 89% of its value (as measured by the Dow Jones Industrial Average).
- 1997-2000: Prior to the bursting of the dot-com bubble, which wiped away almost half the value of the S&P 500, the Shiller P/E ratio hit its all-time high.
- Q3 2018: After cresting a Shiller P/E of 30 during the third quarter of 2018, the S&P went on to lose 19.8% of its value in a 95-calendar-day stretch during Q4 2018.
- Q4 2019/Q1 2020: And, as you likely know, the COVID-19 pandemic helped wipe away as much as 34% in 33 calendar days during the first quarter of 2020.
In other words, history has not been kind to equities if and when the Shiller P/E ratio gets above 30.
However -- and this is a pretty big "however" -- it's quite possible that we've entered a new valuation norm that'll allow stocks to remain substantially pricier than they've historically been, at least on a nominal basis. There are three reasons to suggest that a Shiller P/E of 30 may not be overly expensive any longer.
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1. Access to technology has leveled the playing field
Arguably the biggest reason behind higher stock valuations and why they might be sustainable is the increased access to technology that's helped to level the playing field between Wall Street and retail investors.
Think about it this way: Prior to the mid-1980s, personal computers weren't a mainstream means of entering equity trades on Wall Street. The same can be said for retail investors, which didn't get the opportunity to buy and sell stocks on their own until after the rollout of the internet in the mid-1990s. The dissemination of information prior to these points was often slow, with printed annual reports and newspapers providing investors with pertinent information. In other words, in the 115 years prior to the mid-1980s, access to information was limited, which likely led investors to be more mindful of historical equity valuations.
But that's not the case today. Any investor, whether they're in a 60th floor office in New York's financial district or surfing the web from the comfort of their home, has access to income statements, balance sheets, investor presentations, and news releases at the click of a button. Technology has leveled the playing field to the point where Wall Street pros and retail investors can both be confident about their investing decisions. This ease of information access has played a key role in driving the average Shiller P/E ratio higher since the mid-1990s.
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2. The economic conditions over the past 12 years are unlike anything we've ever seen
A second reason for consistently higher stock valuations over the past 10-plus years is that a variety of economic indicators have been very conducive to growth.
For example, as a response to the Great Recession, the Federal Reserve lowered its federal funds rate to an all-time low of 0% to 0.25%. It remained at this record low for seven years (December 2008 to December 2015), enticing businesses to borrow at historically low rates, and encouraging high-growth companies to innovate, expand, and acquire. At no point in history had the Fed taken such decisive action to push down its federal funds rate.
During the COVID-19 pandemic, the Fed, once again, reduced its federal funds rate back to an all-time low range of 0% to 0.25%. Typically, when the Fed moves to a dovish monetary policy, it tends to stick with that policy for some time. Translation: Expect enticingly low lending rates to spur lending activity, especially for growth stocks, for the foreseeable future.
Additionally, government bonds are paying a pittance around the world, and within the United States. Such anemic yields are practically begging investors to put their capital to work in the stock market. As long as bond yields remain historically low, the value proposition of investing in equities remains incredibly high.
Image source: Getty Images.
3. Recency bias favors more aggressive valuations
The third and final reason behind stock valuations being considerably higher than their historic norms is recency bias. Recency bias describes the idea of a person giving more weight to events that have occurred more recently, rather than in previous periods.
For instance, since the mid-1990s, the S&P 500's Shiller P/E ratio has spent virtually no time below the long-term average of 16.7, with the exception being for a few short months during the financial crisis meltdown in the late 2000s. Over the past 25 years, the average Shiller P/E has been closer to 25, perpetuating the idea in the minds of investors that higher valuations are sustainable for extended periods of time.
Another way recency bias has come into play is with regard to stock market corrections. Since the beginning of 1950, there have been 38 official stock market corrections in the S&P 500 -- official meaning an unrounded decline of at least 10%. In total, 24 of these 38 corrections have lasted 104 or fewer calendar days (that's about 3.5 months).
Of the 14 corrections that lasted longer, 11 of them occurred between 1950 and 1984 – i.e., before technology leveled the playing field and made gathering information much easier. Over the past 35 years, there have been only three corrections that've lasted longer than 104 calendar days: the dot-com bubble at 929 calendar days, the Great Recession at 517 calendar days, and the 2011 correction at 157 days. Looking at this from the perspective of investors, extended periods of downside are rare in recent decades, which provides plenty of evidence that stocks are where you want to park your money, even if valuations appear higher than their historic norm.
Obviously, nothing goes straight up, and the stock market is going to correct again. But avoiding the stock market solely because you believe that "stocks are pricey" is an argument that no longer appears to hold much water.
