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A Rising Tide Raises All Boats, but It Can Only Rise So High

November 21, 2014
Investing
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By Michael Mezheritskiy

Learn more about Michael on NerdWallet’s Ask an Advisor

Let’s talk a bit about equity valuations. Investors love it when their accounts go up in value. As their account values grow, they keep expecting more and more— and then they get complacent. They lose the understanding of what a stock is. It’s more than an ownership piece of the underlying company. Ownership in a stock is the right to a piece of that company’s earnings over an extended period of time.

Investors are very aware of duration when they are investing in fixed income, but they tend to forget that similar rules apply to the equity markets as well. Equity duration is much longer and therefore much more volatile. In its basic form it is summed up in the company’s price to earnings ratio (P/E). This being said, there are macro pieces in place that will affect a company’s earnings over both the long term and short term.

To effectively calculate duration on the market as a whole, look at the cyclically adjusted price to earnings ratio minus inflation (also known as the CAPE ratio or the Shiller index). This is where one can more accurately determine if the market as a whole is overvalued or undervalued, because the average of the previous 10 years is used.

If you just look at last year’s earnings, stocks look a bit overvalued. But when you look at the 10-year average, stocks are about double the valuation that investors would expect for a normal rate of return based on the Nov. 7, 2014, close of the S&P 500.

The stock market is historically overvalued or undervalued, but it always reverts back to its mean. The current valuations tell us that stocks would have to drop almost in half to be fairly valued or undervalued. When you look at the drop in the market during the financial crisis, stocks were only slightly undervalued using this method of valuation.

Today, the most recent valuations tell us that investors should be prepared for dismal gains going forward in the stock market as a whole, as valuations continue to rise and, therefore, continue to become much more stretched. This is why we believe that, to be successful going forward, investors should be much more active and selective of the companies and sectors in which they invest.