There are dozens, maybe hundreds, of ways to value the stock market. And they are all bunk.
There are simple arithmetic calculations such as price-to-earnings (P/E) ratio, which will tell you how much investors care about a company’s profitability. And there are more complicated measures like discounted cash flow analysis or cyclically adjusted P/E that take into account time as well as money.
But at the end of the day, there is no way to know if stocks are “cheap” or “expensive,” and the gasping bull market is proof.
Look at these headlines from the past few years:
• May 10, 2013: It’s not just stocks; everything is overvalued
• Aug. 11, 2014: The stock market: Is it worse than it was in 2000?
• Feb. 21, 2015: The S&P 500 hasn’t been this highly valued in more than a decade
Similar bearish calls exist for some of the top performers in this market, chief among them Amazon.com AMZN, +1.46% which has defied gravity despite talk of how it needed to turn a bigger profit to justify its share price.
If this bull market has taught investors anything, however, it’s that old valuation metrics simply haven’t been worth watching.
At least, not yet.
But, increasingly, it looks like investors are starting to think that valuation means something again. And while Wall Street is littered with terrible warnings about P/E ratios and the CAPE ratio (cyclically adjusted P/E ratio) signaling a pending bloodbath, it’s worth revisiting why some of these measures haven’t worked so far, and why they may be increasingly relevant in 2018 as the market struggles.
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We’re all fools
The mantra I have often used in this bull market is simply “buy high, sell higher.” That advice has worked big-time on the biggest winners in recent memory.
Heck, it often has been as simple as picking the highest flier in the S&P 500 SPX, +1.26% over the past 12 months and simply throwing more money at it despite being late to the party.
Take Nvidia NVDA, +1.95% as proof. This fast-growing chipmaker was the best-performing S&P 500 stock of 2016 by a mile, roughly tripling in the calendar year from about $32 to a little over $100 a share. But if you missed that party and bought it in on Jan. 1, 2017, you still would have snagged a “doubler” over the past 15 months or so, as the shares have surged to over $220.
In 2015, the No. 1 and No. 2 stocks in the S&P 500 were Netflix NFLX, +1.21% and the aforementioned Amazon.com. Both basically doubled that year, but have since go on to make investors boatloads more in profits.
This isn’t exactly a new concept. Business schools and how-to investing books have driven the idea into the ground, referring to it as the “greater fool” theory. Simply put, even if you’re a fool to buy an investment at lofty levels, all you need is a greater fool to buy it at an even higher price.
And let’s face it. For the better part of nine years, we’ve all been enormously foolish.
Make no mistake, it has been a good run and I’m not giving a penny of my money back. But despite the election of a certain wannabe despot with a penchant for fantasy and exaggeration, you can’t ignore facts and figures forever.
Read: This may be the best time for value over growth stocks in 17 years
What we talk about when we talk about valuation
There are plenty of reasons why specific valuation metrics can be “wrong.” But that doesn’t mean that they don’t matter as data points.
Yes, plenty of money-losing growth stocks do just fine with a P/E that is infinite, thanks to a zero in the denominator spot. But the reason investors even bother to look at this calculation is because at its core it measures success. There’s a reason that “the bottom line” is an idiom beyond just the business world, after all.
There’s also a reason that CAPE has come into fashion, since the cyclically adjusted P/E ratio used by economist Robert Shiller smooths out fluctuations because of any short-lived phenomena. Yes, the detailed analysis of Shiller P/E has its flaws and is necessarily bad at calling a top because of its long-term focus. But as a view from 10,000 feet that is insulated from the 24-hour news cycle, it is an invaluable measure of the big picture.
There are a host of other metrics that also have a purpose. Revenue growth matters, because a company can’t keep cutting costs forever. Intrinsic value matters, because customers and investors are fickle but cash is king.
None of those are perfect. And they each are frequently “wrong” as sell signals.
But are you really going to invest without caring about profitability? Or growth? Or the underlying value of a company behind the smoke and mirrors?
If so, you could be in for a rough ride in the next year or two.
Is the tide going out?
This bull market has had a good run. And, honestly, I see nothing wrong with a little bit of greed or a bit of over-optimism among investors.
But it is fair to say that by almost any measure, Wall Street has willingly put a premium valuation on assets across the board. The reasons for this are numerous and nuanced, from a lack of good investment alternatives to U.S. stocks under low-interest-rate policies at the Federal Reserve to well-founded optimism about a robust recovery over the past five or six years, but they are proven out by almost any metric you look at.
So what happens when those reasons fall away, and the premiums can’t be justified?
Well, just look around.
Bulletproof momentum darling Facebook FB, +0.46% is down 12% this year, and Amazon is down 8% in the past month alone. Yes, both have had particularly bad headlines lately, but they’re not alone; both Google GOOG, +0.69% and Apple AAPL, +1.03% are modestly in the red year-to-date to underperform the broader S&P 500.
Furthermore, the best-performing sector in the past 30 days has been the boring but stable utility sector, while information technology has plunged more than 4% as a group.
Right now, the volatility we’ve seen is fundamentally driven by whether investors continue to think stocks are worth buying here and selling higher later, or whether they are worried that these are the best prices they’ll see on holdings for some time.
The market is whipsawing around because, as of yet, Wall Street hasn’t quite made up its mind.
Investors appear to be turning a skeptical eye at long last on companies, including using those out-of-fashion valuation measures that haven’t seemed to matter much in the past few years. So if you want to be ahead of the curve before sentiment rolls over completely, it may behoove you to look at your holdings from a different point of view, one that thinks seriously about data-driven metrics instead of only momentum and “animal spirits.”
As Warren Buffett famously said: “Only when the tide goes out do you discover who’s swimming naked.”
Unfortunately, there are signs that the tide of bullish sentiment is on the ebb in 2018.