We provide here the tools of market evaluation and apply it to the U.S. equity market to assess whether or not the market is overvalues. The techniques and tools shown here can be useful in portfolio management to determine the allocation to put in a certain market. In addition, CFA candidates will recognize material from the equity section, applied to the current market situation.
The chart below shows the performance of the S&P 500 in the last two years. It has gone almost straight up with no significant pull back or market correction. Some argue that the rally was fueled by investment managers piling into equities in fear of missing out the bull market and being caught underweight equities.
Herd behavior is the behavioral bias behind the thinking that the rally has sustained for so long because investors had to join the bull market bandwagon rather than stay on the sidelines and watch the train pass by without them.
The question is: does the market soared based on fundamental reasons such as an improving economy and healthier corporate results or rather due to investors collective biases?
As analysts, we have the hard task of distinguishing between rational market data and irrational/emotional/biased investors. The current bull market situation gives us a great opportunity to see if the rally has been overdone or is actually warranted.
The most common way to assess the realtive valuation of a security or market is through a relative value measure such as the price to earnings ratio (PE). If the PE ratio is higher than historical average, it could suggest that the market is overvalued and the rally may have been overdone.The following chart shows the historical PE ratio of the S&P 500:
Contrary to the late 90s were the PE was clearly over the historical average, the current PE is not alarmingly high or at least not high enough to immediately conclude that the market is overvalued. Please note that the huge peak around 2008 was due to the collapse of the U.S. market which rebounded the following years.
Although the PE ratio is probably the most commonly used valuation measure, Robert Shiller suggested, first in his book Irrational Exhuberance that it may not be the best measure since it does not take account of the earnings cycle experienced by all firms. Shiller introduced the cyclically adjusted PE to take into account the variability in firms’ earnings throughout the years. He utilizes a 10 years earnings per share average rather than the most recent EPS. The resulting cyclically adjusted PE ratio chart for the S&P 500 is presented below:
Cyclically Adjusted Price Earnings Ratio for S&P 500
Judging from both the standard PE and cyclically adjusted version (blue line), the 2013 market valuation does not seem to be out of proportion with earnings. What this suggests is that the rally was simply fueled by improving fundamentals and better profitability.
However, improving earnings could be misleading since; first, earnings can be more easily manipulated and second, the main driver of economic growth is revenue rather than profit. As such, we also analyzed the price to sales ratio trend, presented below:
S&P 500 Price to Sales Ratio
The price to sales ratio provides us with a better picture of equities’ relative valuation. We can see that the ratio has been going straight up since 2012. The level reached is now close to the 2000 level which was characterized by the dot-com bubble overvaluation. This leads us to believe that the price increase was not matched by increasing revenues, but rather by improving margins. However, it is still insufficient data to conclude that the market rally was not justified by fundamentals and was a result of asset managers’ behavioral biases.
As an analyst, it is important to look at both sides of the issue. Very often, analysts try to use available information to confirm their opinion rather than using data to form their views. It is easy to fish for data that supports any thesis. For instance, if I was of the opinion that healthy market fundamentals were the reason for the 2012-2013 rally, I could produce the following arguments:
- The U.S. government reached a deal in early 2013 to solve the problem of the “Fiscal Cliff”
- The Federal Reserve Bank has been committed to maintaining interest rate low and continuing quantitative easing.
- Low bond rate of returns and the fear that if interest rate rises, the value of bond could plummet provides a reason for investor to switch their asset allocation from fixed income to equities.
- The housing market has been improving and house prices were on the rise. (Case Shiller Index, 2014)
- The U.S. unemployment rate had been declining steadily since 2010 and dipped below 8% late in 2012. (U.S. Labour Bureau, 2014)
This however, does not prove anything, since there is an equally convincing bearish case that could have been made. Let us now look at the argument that the market rally was fueled by managers trying to catch up with the herd and their benchmarks.
Catching up to the herd
“Never, ever be wrong on your own” – J. M. Keynes
As was eloquently explained by Jeremy Grantham in his famous quarterly letter in 2012, asset managers suffer from career risk (Grantham, 2012). If they fail to beat their peers and benchmark, asset management firms will lose assets since clients would rather invest with outperforming firms. Therefore, even if asset managers have a disciplined investment policy focused on long-term profits, they may not be able to implement their investment strategy because of client pressure. Investors may move their money to another firm if the fund has a bad quarter or if he fails to participate in the market rally. This could translate into a loss of job which Grantham calls career risk. Very few asset managers can afford to ignore pressure from clients to participate in market rallies.
John Maynard Keynes mentioned in 1936 that you must never, ever be wrong on your own (Keynes, 1936). In asset management, it means that even if some managers did not believe in the fundamentals of the stock market rally, as discussed earlier, they could not risk staying out of the rally and not investing in equities. Since the S&P 500 returned 32% in 2013, it would be hard for money managers to justify staying in cash throughout the year. The result is for asset managers to “go with the flow”, which translates into herding behaviour. They want to avoid the possibility of being the only one wrong and therefore losing both their credibility and their job.
In addition, since asset managers are judged, and often compensated based on how they fare relative to their benchmark, there is an additional pressure to provide investors with a return at least equivalent to the benchmark. It is interesting to note that Jeremy Grantham also indicates that the constraints and pressure given by a benchmark could, in the long run, have a negative impact on performance (Grantham, 2012). As evidence, he compares a personally managed portfolio with one managed by his firm (GMO LLP) which is constrained by a benchmark. Throughout the years, his personally managed portfolio, free from peer pressure and constraints, drastically outperformed his company’s portfolio.
This suggests that the fear of missing out and the herding behaviour exhibited by professional fund managers could be rooted in the fact that they are compared to each other and to their benchmarks. The consequences of being wrong collectively if the market turns out to be overvalued, are benign compared to the career and business impact of staying out of the rally and underperforming both peers and benchmark.
Of course, some asset managers are less shackled by their benchmark and are free to pursue their investment strategies. For instance, Warren Buffet’s Berkshire Hathaway, who was also bullish throughout 2013 but did not invest in “hot” stocks such as Twitter or Facebook, reported on March 1st 2014 that they had underperformed the S&P 500 (they returned 18.2% relative to 32% for the index). Warren Buffet arguably can afford to follow his own investment policy and turn a blind eye to what his peers and the market are doing given his firm’s stature. However, generally managers do not have this luxury and must follow the herd or risk losing their jobs and clients.
So…Overvalued or fairly valued?
On one hand, a credible bullish case can be made that the U.S. economy is improving and that the valuation is in line with historical standards. On the other hand, it is true that asset managers (and analysts) tend to demonstrate a herd behavior where no one wants to be caught offside. This behavior often amplifies market movements in both direction which means that analysts and investors should be careful whenever there seems to be a consensus opinion or a prolonged market movement.
As hard as it may seem, a financial analyst should be aware of the fundamental and behavioral forces behind the market while trying to remain above the fray. Personally, I believe that it is more sustainable in the long run to trust your own approach and analysis rather than follow the bandwagon. Obviously, as Jeremy Grantham mentioned, this is easier to achieve as an independent trader than if your performance is constantly measured against benchmarks…