Should We Be Worried About Valuations?

Should We Be Worried About Valuations? image

The State of the Market

If you want to start an argument about the state of the stock market, the topic of valuations is usually a pretty good place to start. And to be sure, the topic is fairly complex. For example, valuation levels morph over time. What was extremely overvalued from 1925 through 1985 has become the low end of the range for the last 35 years.

Then there is the issue of absolute valuations versus relative valuations - meaning the level of valuations relative to interest rates. The simple point here is that when rates are high, they can be viewed as competition to stocks (especially those dividend-paying companies). Conversely, when rates are low, it can be argued that stocks are a better way to try and generate income. As such, demand for stocks is higher when rates are low. Especially when rates are at either generational or all-time lows, which is an environment we've been in for quite some time now.

However, in perusing the dozen or so valuation metrics I review each month (including various measures of P/E's, Price-to-Dividends, Price-to-Sales, Price-to-Book, etc.) there can be no arguing that valuations - especially absolute valuations - are either at or near record highs.

Yes, I said it; some valuation metrics are at record highs. Go ahead and let that sink in. Kinda gives you a chill, doesn't it?

With this data currently being splashed everywhere, even grizzled veterans of the stock market game can be seen/heard paying attention to and/or questioning valuations. So, the question of the day becomes, should investors be thinking about heading to the sidelines? Or at the very least, taking some chips at the table?

The Short Answer

Cutting to the chase, the short answer is, maybe yes, maybe no.

You see, valuations tend to become extreme for two basic reasons. First, when the economy experiences a recession, it follows that the E (earnings) in the P/E ratio falls. But then as stocks begin to discount better days ahead, the P (price) rises. The key here is to understand that this causes the P/E ratio to surge because the P is rising while the E is still falling. So, we tend to get extremely high P/E ratios as the economy emerges from recessions. Sound familiar?

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The opinions and forecasts expressed herein are those of Mr. David Moenning and may not actually come to pass. Mr. Moenning's opinions and viewpoints regarding the future of the markets should ...

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