This Might be a Stock Bubble, but Valuation Metrics Won’t Help you Understand that

There’s a lot of chatter these days about extended “valuations” and the “bubble” in the stock market.  For instance, I was reading this piece on MarketWatch by Brett Arends which states that we’re now in the “third biggest stock bubble in US history”.  Arends goes on to cite Andrew Smithers of Smithers & Co. and his analysis showing that the US stock market is overvalued by 80%.  EIGHTY PERCENT!  That sounds like a huge number doesn’t it?  The only problem is, Smithers has been saying this the entire way up:

Smithers uses Tobin’s Q and other valuation metrics to gauge the “value” of the stock market.  And I don’t mean to jump on Andrew Smithers.  But there’s a good lesson to learn here.  Looking at “value” is a lot like looking at “beauty”.  You might think you know what beauty is, but if the market is a Keynesian beauty contest where you’re trying to judge the beauty of contestants relative to the way the other judges perceive beauty then the only thing that matters is what the other judges believe.  Using some historical benchmark of “beauty” could be entirely useless if the benchmark of “beauty” has shifted.  In essence, picking the most “beautiful” contestant isn’t a contest involving your ability to understand “beauty”, but it’s really a contest about your ability to perceive what the other judges THINK is beautiful.

In the case of the stock market we’ve now seen a 20+ year period where stocks are “overvalued” by several metrics (Shiller CAPE, Tobin’s Q, Market cap to GDP, etc).  So I think it’s worth asking yourself how useful all of these metrics really are.  Can you afford to go through a 20 year period relying on a rear view mirror dataset assuming that the market is overvalued when the other participants might not be using the same gauge of “beauty” as you are?

I’ve spent a good deal of time over the last 10 years trying to put “value” metrics to work.  I even cite them here on occasion just for perspective.  But I have found it nearly impossible to apply these metrics in any useful sense.  And if the last 20 years tell us anything it’s clear that many of these valuation metrics are junk and relying on them will lead you astray.  None of this means there aren’t potential risks in the market at present or that stocks aren’t in a bubble.  It just means that relying on these metrics to tell you that is probably not a very good indication of bubbles let alone anything….


Got a comment or question about this post? Feel free to use the Ask Cullen section, leave a comment in the forum or send me a message on Twitter.
Cullen Roche

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services. He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance and Understanding the Modern Monetary System.

More Posts - Website

Follow Me:


    When will this frickin’ thing burst!? ;-)

  • Alberto

    If my has car not crashed yet despite I’m going at 200 mph it means I can go on because it has not crashed yet. Nice circular way of thinking. Nothing can surprise me anymore.

  • Cullen Roche

    How do you know we’re going 200 mph? Not saying we’re not, but I do wonder what the rationale for this assumption is….

  • Andrea Malagoli

    Cullen, you basically implying that markets do not respond to fundamentals, at least classical fundamentals, so that all that remains is following trends.

    To your point that the markets have appeared overvalued for the past 20+ years, note that the returns on the markets for those 20+ years has been sub-par. In fact, for some periods fixed income has had higher returns. Also, there have been two “one hundred year floods” in the span of ten years, which seems to indicated a higher propensity of the markets to crash.

    So, I am not sure that we can fully dismiss the notion that those indicators are “junk”.

    Nobody considers those indicators has “timing” signals, if that is what you are implying. However, those indicators seem to relate pretty well to the long term expected returns on assets.

    No, nothing is going to tell us when the next “bubble” is going to pop. At the same time, implying that this time is different and that valuation does not matter is equally dangerous … in the long term.

  • Alberto

    Shiller CAPE, Tobin’s Q, Market cap to GDP etc… are not there to tell me I have to sell or buy, they are just telling me that respect the past the market is cheap or expensive. I don’t know if the market is mean reverting in the future like it was in the past but my decisions will be based on a lot more than a set of metrics. What you do can be totally different but at the same time we can be both wrong or both right. Do you really think that investing is a science ?

  • http://home Midas II

    This may be dumb. A subway ride was once 10 cents and now its $2.50. Every thing has gone up, a dollar has a lesser value than in the past. A $10 dollar stock today reflects the same change: the same stock was once $2, 20 years ago when the company was as good as now. Even the last 10 years show the CPI rising. The whole market deals in today’s dollar, is this taken into account when talking “Bubbles”? Plot a slope for the CPI vs. the SP 500 market, over time don’t they both go up? I suppose a “Bubble” is when the rise is more than expected, but who knows what to expect without a crystal ball. We may be in a new paradigm and can’t see it.

  • Pierce Inverarity

    Valuations are always ratio driven, so yes, they take into account inflation.

  • pliu412

    Actually, there are two factors here

    1. Who are the judges or buyers for each day?
    2. What are metrics used by those buyers for trading?

    Metrics are “subjective” assumptions in the minds of those buyers in a particular day. Metrics do not matter if they are not used by those market buyers.

  • Cullen Roche

    A few things:

    1) It’s always different this time. No economic environment or market environment is ever the exact same. I know markets are cyclical, but valuations don’t have to be cyclical in the same sense.

    2) My point here is that what we perceive as “value” is not relative. You have to think in absolute terms here. There’s absolutely not reason for the market to trade at a 10 PE ratio again just because it did in 1950 or something. Just like there’s no reason for me to think that an overweight woman is beautiful just because some Greek guy in the 7th century BC did. But we view valuation metrics as if they’re some ironclad rule of law that cannot change. Perceptions changes. And valuation metrics need not mean revert just because some past relative market environment says the market once traded lower….

  • Mr. Market

    - Valuation metrics are a VERY good gauge for measuring whether or not a market is overvalued.
    – The problem is that “Markets can remain irrational longer than one can remain solvent”.

  • John Daschbach

    “It’s always different this time. No economic environment or market environment is ever the exact same. I know markets are cyclical, but valuations don’t have to be cyclical in the same sense.”

    Exactly. In reality the economic environment is something that can only be described to reasonable approximation with a huge set of parameters (millions to many billions or more depending). Everything fundamental to economics has changed throughout history, population, food supply, education, medicine, stored knowledge, ……

    It’s not possible for humans to understand this at a level that allows even for in sample regressions to have statistical validity and extrapolations have variances which are then so broad as to be meaningless.

    But there are long time limits (boundary conditions that change in time) that have to be satisfied. Real assets are just a store of past productivity and natural capital. In a world where the value of intellectual capital is increasing far beyond linear it’s impossible for humans to assess value. It is a different world. But it has always been that way.

    The economy is a far from equilibrium, chaotic, system. We know what the long time limits are, but we have no way to predict in any statistically valid way what the short term (e.g. tens, hundreds, thousands of years) fluctuations will be (in magnitude, and thus much less timing).

    It takes both statistics and intuition to hope to beat the median performance for any local economy and far more to beat the global median. We know from almost all data that gains at any scale (individual, city, state, country) have a Pareto like distribution. Using things like indexes (weighted means) to try and describe this is not very informative.

  • LVG

    People have a hard time thinking in absolute terms. It’s much easier to think in relative terms. That’s why this sort of nonsense is always being trotted out as some useful tool for predicting future market performance.

  • Mark Caplan

    The beauty contest judges in this case are the corporations themselves, since they are doing most of the buying, of their own stock, with money borrowed at rates that are too low to pass up.

  • Andrea Malagoli

    It is true that things are never the same. However, your argument implies that there is no basis for investing since “value” appears to be nothing but a perception and it could change at any time. However:

    1) There is no denying that those indicators that you call “junk” have had a pretty good explanatory power of future long term performance for the past 100 years.
    1a) The indicators have good explanatory power on the “real” market performance, i.e. including adjustment for inflation

    2) Note, to your point, that it is not the “level” of the indicators that has had significance, but the “trend” — i.e. there is periodicity in the phases of expansion/contraction of those indicators
    2a) One needs to questions why multiples are expanding ahead of earnings and why this is the case

    3) Criticizing the existing indicators is ok, but what is the alternative then? If we do not invest based on valuation, what else should we use?

    4) The case for permanently higher valuations is a dangerous one to make (as Irving Fisher). The “it is different this time” without justification has proven a dangerous argument to make

  • Andrea Malagoli

    This statement does not mean much. There is no such thing as an “absolute” valuation.

  • Andrea Malagoli

    That alone, and the fact that corporations are happy to borrow to buyback shares instead of investing and/or retiring debt, raises questions about the future profitability of companies that are not investing for the future.

    The last time buybacks where so high was in 2007.

  • Cullen Roche

    I am not arguing that we’re in a period of “permanently higher valuations”. I am saying I don’t find the metrics helpful. I don’t care if we’re in what you define as an “expensive” market. It’s like telling me I don’t know what beauty is because you define it one way and I define it another way. Your concept of beauty could be totally useless to my ability to succeed in winning the beauty contest. And since there is no uniform or agreed upon concept of “beauty” or “value” then it’s a meaningless tool. What we find to be beautiful today might not be beautiful in 10 years.

    Maybe some other people know how to apply these tools. Maybe you know what “value” is and I don’t. That’s fine. But all I know is that these metrics have led people astray for 20 years and that’s a pretty devastating time period if you ask me. Who can afford to go that long being misled by a metric? Not me.

  • Anonymousone

    Fundamentals went out the door in 2009 when we changed decades of accounting consistency pressuring accounting boards to benefit the collapsing banks. At that time government and finance officials had to be terrified with a 50% haircut in stocks. Ultimately we would have come out of recession and fundamentals would have put us higher but not where we are today at S&P 2000. Recall that in 2011-2012 period we were still having those wild swings of 400 and 500 points (DJ). Clearly having recognized the wealth effect, I always wondered if Bernanke quietly told the bankers “I want the market up” much like those shotgun banking marriages initiated by the Treasury…and up it went with a bullish engulfing of American asset prices probably good for a weakened nation but questionable based on fundamentals.
    A long time ago during my collegiate days between a few beverages I wrote a paper on IBM’s position as a market bellwether. For me it’s still a market bellwether and symbolic of this market, not much growth but a good deal of financial engineering. As they say…it is what it is.

  • GLG34

    I think the concept of value has been burned into our brains in the investment community. The idea that it might be a totally nebulous or useless concept is very disturbing. Some might even paradigm shifting. If Cullen is right that value is a meaningless concept then what is the alternative? How do we measure financial assets which aren’t real in the same sense as output?

  • Andrea Malagoli

    These metrics have indicated that market returns would be sup-par for the past 20 years. If you look at the past 20 years, the stock market has not exactly had a “stellar” performance.

    My point is different. It is not the “level” that matters, but the “change on the margin” (a point made by others before).
    See, you do cannot know if there is a “right” valuation level. However, you can observe when valuations are expanding “relative” to the expansion of earnings. No matter what the appropriate level is, it is hard to argue that this divergence can continue forever … unless you assume that the rate of earnings growth will find a way to accelerate in the future to rates not seen in the past. Another way to achieve a similar result would be to accelerate the rate of share buybacks by leveraging, and that also cannot continue forever.

  • howdy

    My thoughts on this: margin debt is really high, maybe not at a record high. But besides margin debt companies also use other forms of debt, they borrow money at cheap rates to buy back stocks. They are swapping outstanding shares for coporate bonds and loans. This swapping artificially increases their P/E and stock price but it makes the companies very vulnerable for interest rate increases (which are not going to happen any time soon). The small cap companies are lagging behind because they can’t get the same amount of buybacks done. I think the small cap companies will collapse further and bring down the rest. Yellen is also saying not to buy small cap stocks “as their valuations are stretched.” I think a healthy 10% correction can results in a further 20-30% correction because of the overly leverage companies and their leveraged shareholders.

  • Cullen Roche

    The US stock market has generated a 9.29% CAGR for the last 20 years. The facts simply don’t support your assertions.

  • WMO

    A tweet from Doug Kass on the subject

    @DougKass: The US equity market may appear attractively priced, but as Dolly Parton said, “You’d be surprised how much it costs to look this cheap.”

  • Stephen

    As far as I am concerned you are in a bubble if you have passed the point at which the leverage deployed allows for orderly exits when faced with undesirable surprises.

  • Alberto

    so because it did it, it will do again. You, like me and 100% of people are stongly biased. I know and admit it, while it seems you’re spending a lot of time convincing yourself you’re different. I admit you’re much better than Barry Ritholtz a stongly biased person which is teaching the others about how not to be biased. Pretty normal behaviour, we’re not much more than naked apes fooled by randomness.

  • Dan

    You write, “I’ve spent a good deal of time over the last 10 years trying to put “value” metrics to work. I even cite them here on occasion just for perspective. But I have found it nearly impossible to apply these metrics in any useful sense.”

    However, there are those who do have a decent track record of timing the market to some degree. The most basic Warren Buffett approach is just to buy less when the market gets expensive (Carl Icahn recently noted the market is expensive and he can’t find much to buy).

    You write, “Using some historical benchmark of ‘beauty’ could be entirely useless if the benchmark of ‘beauty’ has shifted.”

    Assuming there’s a new normal or that things have changed has been dangerous over and over again. Tobin’s Q has been statistically predictive — including in the past 20 years. That includes two giant bubbles — one in dot-coms and one in real estate and derivatives. And yet Tobin’s Q and other metrics could have prevented investors from losing over 50% of their wealth on both occasions.

    The risk-adjusted returns for stocks have been terrible in recent years. You could have bought bonds in the late 90’s and gotten the same returns up to today with far less volatility. If you’d bought gold or other commodities, you’d have done even better. When you buy into an expensive market you are buying into a Ponzi scheme frenzy. You bet on prices going up. Everyone pours money into a market like that — but only those who sell first will get it back.

  • Conventional Wisdumb


    Data like this is actually very endpoint sensitive. Why be arbitrary?

    If you used Jan 1 2000, till now as your starting point CAGR would be about 3.55% even with the current run up which grossly under-performs fixed income during that period.

    The conclusion I draw from this data is that the time to invest is when these metrics are lower than average versus higher than average but that would mean timing and probably not being invested for long periods of time which is probably an impossible feat for most people.

    The next 10 years should be very weak assuming these metrics are valid. Sadly we won’t know till after the fact which makes this data less than actionable.

  • Cullen Roche

    He said the returns were poor over 20 years. I was simply using his time frame….Clearly, the returns have been quite good despite “expensive” markets according to these indicators. Anyone using these indicators in the last 20 years has gone through long periods of poor performance thinking that the markets were riskier than they really were….

  • rzbatman

    So, you are saying Tobin, Shiller & Buffet are fools – and their processes are Junk?

    I was about to buy your book – but you clearly don’t know what you are talking about – probably should not waste my money.

    When things are expensive – you don’t go 100% to cash, but it is good to know where you are – or not I guess according to your logic. It is all just a Beauty contest – so stocks can go higher for ever? Think I have read that one before – will stick to my bottoms up process which has worked for me for years now.


  • Cullen Roche

    Of course I am not saying Buffett, Shiller and Tobin are fools! How did you make that connection? Those men are all geniuses who I’ve consistently praised on this site….

    My book is a top down macro view of the world so if you’re not very open-minded to that sort of approach then you probably won’t like it much.

  • DanH

    John Hussman is probably the best example of how this reliance on these value indicators can blow up a portfolio. That guy now has a negative 10 year rolling return because he’s thought the markets were “overbought, overvauled” for so long.

  • JanVer

    The whole idea of value investing is an obvious contradiction. It assumes that you know the true value of the market in the short-run, but rely on the market to be efficient in the long-run to “come around” to your view eventually. If the long-run is just a sequence of short-runs then this view obviously contradicts itself and is promoted by people who want to convince themselves that they’re smarter than the market.

  • rzbatman

    To quote you, (Shiller CAPE, Tobin’s Q, Market cap to GDP, etc) are “JUNK”.

    What am I missing?

    Would you have written this blog post in 2008? I really depends on the time frames you choose.

    People that understand how to use value metrics – adjust their portfolio’s based on these indicators – again, not going 100 percent to cash, but moving some capital to lower valued assets, or even some cash to have as dry powder.

    I am very interested in the Macro View, especially as it relates to the FED – this is why your book was next on my list – but the views you are presenting are very naive in my opinion.


  • Cullen Roche

    I am simply saying that the indicators are junk. That doesn’t mean that the people using these metrics on occasion are junk. I think Shiller, Tobin and Buffett are geniuses.

    I guess I personally don’t see the benefit in using these indicators to implement a strategy. For instance, let’s say you thought the market was “cheap” in 1973 and for 20 years you used a 80/20 (stock/bond) allocation. You would generate a 11% return with a sharpe ratio of 0.3. But then in 1993 you notice that valuations look expensive. So you switch to a 60/40 allocation. For the next 20 years you generate a 8.3% return with a sharpe ratio of 0.5. But if you’d maintained your “higher risk” allocation of 80/20 you’d have achieved a 8.9% annualized return with a 0.47 sharpe ratio. In other words, adjusting your portfolio for the higher valuation and what you perceived as a “higher risk” environment did not help you. It hurt you.

    I can understand why people find my rejection of value investing “naive”. It’s a jarring concept that we’re so irrational that maybe we can’t actually understand what “value” is to begin with in a complex dynamic system. If you can understand it then great. But I am not pretending to be smart enough to know when the market is a good “value” and when it isn’t. If that makes me “naive” then fine. But at least I am aware of my weaknesses well enough to know that I can’t benefit from this particular approach….Good on you if you can. You’re a better man than I am.

  • rzbatman

    Thanks for responding – will continue to read your blog posts, and will keep your Book in my Amazon Wish List.

    The main reason I was going to buy it was the praise from James Montier, GMO – who I think would be siding with me, based on his writings.


  • rzbatman
  • Geoff

    Using your definition, High Yield bonds would probably qualify as a bubble. They aren’t very liquid at the best of times as they aren’t traded on an exchange like stocks. If you want to sell, you need to get a bid from a dealer. If conditions take a turn for the worse, High Yield bonds will likely go “no bid” as my bond friends like to say.

  • Cullen Roche

    Oh, no doubt. James and I corresponded about the book quite a bit. He actually edited it for me from top to bottom. He’s an amazing guy. Incredibly generous of him. And yes, we don’t see eye to eye on the value investing stuff. He’s far smarter than I am so maybe he just knows how to put it to use better than I do. To each his own, right?

    If you should decide to read the book I’d love your feedback. Sorry you didn’t like my point of view here!

  • The Other Matt

    I think Cullen is as close to the crux of investing when he describes the market as players judging the judging of a beauty contest i.e. pricing of markets driven by investor emotions and behaviors. Furthermore, as evidenced especially by the last two years — completely disconnected from the economy. Really?! A negative 2.9% GDP print and the markets are ho-hum? Whatever bro — don’t fight the Fed.

    In the long-term if we believe that innovation, productivity and the like drives developed economies then you can invest on that premise alone. And if well-diversified, one can comfortably save for a future when you stop working full-time and be assured of producing a steady stream of income through the end of your plan.

    On paper, investing for the long-term does work, but the reality is that most people’s long-term investing window (once the mortgage is paid down, the kids are through college, weddings paid for, etc.) is only 15-20 years before retirement — at least here in the US that is the case for a large portion of the population.

    So if the reality is that your maximum saving/investing period is only 15-20 years then you can’t afford to get it “wrong” and experience a massive downturn such as 1929-32 or 2007-2009. It is much too difficult to come back from a severe draw down of 40% or more. So what is an investor to do? Diversify like mad, but one also has to try to determine as best they can, where markets currently sit with respect to all the “value metrics” out there.

    Cullen you’ve said it before, but at this point any investor/saver is playing a probabilities game and given today’s standard value metrics it seems reasonable to consider the probability of the next cycle in the markets would be to get “cheaper” …. someday.

  • Dctodd27

    Oh man I’m late to this post, crap now I’m gonna be at the bottom….

    Anyways…..Cullen! If I could shake you through my iPad I would! Why didn’t you write this article in early 2009? Because market returns were lousy, of course. So lousy in fact that returns from 1995 to that point were roughly zero, a fourteen year period of nothing!

    And you seem to miss completely the fact that these same valuation indicators you say aren’t useful were in fact indicating “undervaluation” (read: sub-average) at the time. And now it’s surprising that the market returns have been above average since then?

  • D Phillips

    Using a single metric to evaluate the market using backward looking data is risky. There are simply to many variables. General conditions in the 20’s, 30’s, 40’s, 50’s, 60’s, 70’s, etc, were all different from each other and all different from today. The only thing the same is people. We are still driven by fear and greed.

    At the end of the day it makes no difference what I think a stock is worth, using whatever methods I use. My stock is only worth what the market collectively thinks it’s worth and what I think and my rationale make no difference. There is as much, if not more emotion involved as analytics.

  • Dctodd27

    Cullen, a huge chunk of those returns came in just the last 5 years. Shouldn’t that tell you something?

  • Cullen Roche

    Yes, I think it’s critical to develop an investment plan that deals in probabilities and not certainties. But the biggest uncertainty in the market is arguably the perception of others. So developing a strategy that relies specifically on being able to perceive how others view “value” is susceptible to substantial errors. I develop a probabilistic investment approach using a macro model that doesn’t rely on having to guess how other people view the market. I simply view the market for what it is and not what others might think it is.

  • Cullen Roche

    Is that right though? How many people were screaming about how cheap the market was in 2009 using CAPE, Tobin’s Q? And if they did say the market was cheap the market became expensive again by 2010. So these models still failed to keep anyone heavily overweight in equities during an epic bull market.

  • Cullen Roche

    Why does it matter if they came in the last 5 years?

  • Anonymous

    Because it means most of the return occurred only after the indicators you mention above signaled undervaluation in 2009…

  • Dctodd27

    Grantham did. Hussman identified the market as undervalued in real-time, though he obviously has had his issues using that information profitably.

    The reason why value investing works is because most people use cyclical bull markets such as the previous 5 years to convince themselves that it doesn’t.

  • Dctodd27

    Sorry, that was me…

  • Cullen Roche

    I still don’t see why the 2009 period matters. So you turn very bullish for a brief period in 2009 and then by 2010 these metrics are telling you the market is significantly overvalued again and you turn far less bullish and then proceed to miss out on a huge bull market. It’s not like CAPE and Tobin’s Q went through 10 or 20 years of telling you the market was cheap as they did in the 70s and 80s. These indicators went bullish for mere months in 2009. I don’t see how that’s helpful at all.

  • John Daschbach

    This is true only in as far as it goes. In the infinite time limit stocks are not worth more than the underlying share of future productivity they have claim to. That is, if we went back to being hunter-gatherers for hundreds to ten-thousands of years then most current stocks would have zero value in that future.

    There is a clear theoretical upper bound on stocks. Let all companies merge into one single company. The returns on that single stock have an asymptotic limit of all productivity minus that required to support the population (minimal food, shelter, clothing, and health care).

    But we operate far from this limit, so stocks are “only worth what the market collectively thinks it’s worth”. Given that we are so far from the two limits the use of valuation measures is, as Cullen notes, mostly junk.

  • SS

    Hussman is a great example of the dangers of relying on this approach.

  • Dctodd27

    I’m not sure what the objection is. You’ve had below average returns following overvalued readings, and above average returns after undervalued readings. And despite an almost 200% return the last 5 years, the market’s 20 year return is still slightly below average. Again, it’s easy to make your argument at cyclical bull peaks, why don’t we hear these arguments after bear markets?

  • Dctodd27

    Hussman’s problems don’t relate directly to this issue. They have to do with attempting to forecast shorter term market returns, and also hedging, both of which are extremely difficult if not impossible to do.

  • Cullen Roche

    That’s not true though. Tobin’s Q and Shiller’s CAPE have both been saying stocks are expensive since 1993. There was only a very brief period in 2009 when they both moved lower, but even then they were both giving off historically high readings and people using these metrics (like Smithers and Hussman) were still saying the market was expensive then and all the way up. And since 1993 the total return of the S&P 500 has been 9.3% annualized. These indicators would have had you underweight stocks for much of the last 20 years if you’d followed them….

  • Geoff

    Doodes like Richard Russell have been bearish for at least that long. :)

  • Dctodd27

    Cullen, I respect and appreciate the attention and the effort you put into replying to my and others’ posts. Despite both our best efforts, however, we’re just not on the same page on this issue.

  • Dennis

    OK, I ordered your book. I shouldn’t comment until I read it, but. The stock market “bubbles” are caused by too much credit chasing overpriced assets (As you know). In 1999 everyone EVERYONE upgraded their computer systems based on the fear that all would crash (except Macs), due to the Millenium issue. Based on the metrics of the underlaying companies, future valuations and thus stock prices were heading up like an asymptote. In 2008 the amount of credit unleashed by the banks was astronomical, pushing stock prices to about where they are today 2014. The metrics say “bubble”, not considering that 1.5% inflation (compounded annually) since 2008, makes the current “bubble” illogical. Cullen is right. Toss the metric and use common sense.

  • CharlesD

    I’m in the business of trading the S&P 500 over the intermediate term (1-6 months) using systematic (mechanical) models. The factors I have found useful are Technical (trend, breadth, counter-trend, thrust, etc), Sentiment (being contrary) and Fundamental (measures of monetary policy, changes in credit spreads, etc.) I have found measures of “Valuation” are of no value over these time horizons. Right now the Fundamentals are solid, Technicals are OK
    and Sentiment is poor (too much optimism , more new issues, etc). Overall, then, we are still in a bull market so some equity exposure is warranted. . While a drop to cool some of the speculation would not a be a surprise, based on history, it shouldn’t be more than 8% or so. While nobody knows anything for sure, of course, it appears that people like Hussman are out to lunch with their anticipation of a major decline. He’s focused on the one factor which is the least useful, IMHO (Valuation)

  • Cullen Roche

    Oh well. I am sincerely curious if I’ve misinterpreted how to implement these metrics. If someone has a good idea where I might be going wrong then I am all ears. Thanks.

  • Cullen Roche

    Thanks. Hope you enjoy. Let me know what you think when you’re done.

  • Dctodd27

    Tell you what. You’ve got my email address. Drop me a line if you’d sincerely like to continue the discussion. Not sure this is the best medium of exchange at this point (seeing as how there are lots of other comments surrounding ours).

  • Mr. Market

    No. The indicators are NOT “junk”. These are valid metrics but as John maynard Keynes has said “Markets can remain longer irrational than one can remain solvent.”

    E.g. Steve Keen made a bet (which he lost) that australian real estate prices would go down in 2010 yet they didn’t. Because China started to inflate its economy with LOTS of credit and Australia benefitted. Now real estate is at 8 to 10 times annual income in places like Sydney. Any value over 3,5 to 4 times annual income is bubble but that doesn’t mean the real estate bubble in Australia will pop tomorrow.

    The metrics are good but it’s the timing that matters.

  • Cullen Roche

    And as Keynes also said, “in the long run we’re all dead”. I’d like a metric to work while I am alive, not while I am dead. 20 years is an investing lifetime for many people and way too long for an indicator to not work….

  • Mr. Market

    That’s why you need to look for other indicators as well.

    One VERY important indicator is the credit market. And they DO send some worrying signals.

    E.g. Janet Yellen has warned that short term are going to raised. For me that’s a “shot across the bow”. And frankly I am NOT surprised. I have a good clue why it’s going to happen.

  • WMO

    The debate about these valuation metrics is not new as every Financial website (including this one ) has cited them over the last 2 years for one reason or another but mostly to cover their asses just in case the market is overvalued . If you were around in 1998-2000 you should recall seeing the same thing as many value investors were exiting the markets or owned old economy stocks that were severely underperforming techs .

    All there is to understand about valuations is the following : What is preferred the rate of return ? 15% 10% or 5% ? Its yours to pick . If you want a 15% you may be struggling to find opportunities now . If you are happy with 5% there are plenty of opportunities .
    If you only invest when ‘the market ‘ is cheap then you will miss out on many opps as there are always undervalued stocks even when the overall market valuation is very high .
    In 2000 old economy stocks were cheap by every value standard but the overall market was not .

    In summary you are free to waste your time on trying to call ‘the market’ or decide if it is overvalued BUT all that really matters is you preferred rate of return . If there is nothing for you today you will be in cash and if not you will be invested .None of this says anything about a bubble or crash or anything else for that matter .

  • Mr. Market

    Why not subscribe to a GOOD newsletter ?

  • Anthony

    What would be interesting would be to run simulation of portfolios using only these statistics parametrised on a rolling window ? It is hard to do these without anyone accusing of having a look ahead bias.

  • Anonymous

    20 years of overvaluation. And 20 years of poor long term returns. Cullen has some great insight regarding monetary system. Otherwise he’s just another hack claiming that he knows how to time the market. Maybe, but If so, i dont think he’s going to let me know when it is time to sell. Frustrating to me that a seemingly intelligent person would seriously evaluate an investment philosophy based on performance over a half cycle. That is straight from the textbook of misleading the retail market.

  • Cullen Roche

    I actually don’t claim to be able to time the market and in fact, a central tenet of my portfolio construction is based around getting away from the idea that you should “beat the market”. I use a cyclical model using a probabilistic based methodology that is constructed around the idea that you can’t time the market, but can reduce variance and risk through cyclical portfolio adjustments and applying an asset allocation that is appropriate for your personal risk parameters. If you understood my methodology (which, to your credit, I’ve never disclosed in any comprehensive manner) then you’d know that I actually don’t advocate market timing in the traditional sense.

  • Cullen Roche

    Also, the 20 year compound annual growth rate of the S&P 500 has been about 9.3%. So it hasn’t been “poor”.

  • Dinero

    The logic of that comparison is not valid. You can’t summate the returns of the best of the alternative stategies for both 20 year periods because there is no evidence that someone following the second strategy in the second 20 year period would have the reurns from the first 20 year period.

  • Stephen

    I’m an old man whose had plenty of time to see market conditions of all kinds. What I know is simple. Only greedy people wait for markets to go down before they go to the bank with their profits. Liquidity is so important that waiting for bids to disappear before you hit the exit is a fools game. Equity is obviously more liquid than some other asset groups and yet the same behavioural tendencies to follow the trend keep people in play longer so in the end they also give up more before they give up trying to get long.
    Might be better not to call all this stuff ‘indicators’ at all. Less confusing.

  • Geoff

    Well said, Stephen.

  • Andrea Malagoli

    Not really. Only if you cherry pick the period, but in general the returns have been lower.

  • Andrea Malagoli

    Again, this return figure is true only of you “cheery pick” the period.
    Most of the returns happened in the early phase of the period pre-2000, with many years of double digits returns. Then returns have basically stagnated or been very volatile for the second part of the period.

  • Andrea Malagoli

    Again, this return figure is true only of you “cheery pick” the period.
    Most of the returns happened in the early phase of the period pre-2000, with many years of double digits returns. Then returns have basically stagnated or been very volatile for the second part of the period.

    See here:

    In fact, if you perform some more careful analysis, you’ll find that there is consistency between the levels of those indicators and the future expected returns on a 10-15 yrs scale.

  • Cullen Roche

    I used that 20 year period because 1993 is the year when stocks became “expensive” according to those metrics…

  • Johnny Evers

    What I get from this post is that Cullen is a young man who has come of age in an era in which valuations seemingly don’t matter — you make money from riding trends and playing momentum.
    Also I don’t think he sees a stock (for example) as a real investments that provides claim on future earnings (which can be measured and valued) but rather as a financial asset which price is set by some other metric (perhaps the market’s collective willingness to value each others assets at a high price.).

  • Cullen Roche

    They’ve been lower, but only very marginally. And that assumes that the previous periods weren’t abnormally high.

  • Cullen Roche

    no one is “cherry picking” the 20 year period. This is the period during which stocks have been expensive according to the metric you’re defending!

  • Cullen Roche

    The valuation of the S&P 500 hasn’t mattered since 1993 according to these metrics. You literally would have been screaming “overvalued” for 20 years straight as the S&P marched to 20 years of 9%+ returns. That’s a lifetime for many investors! How does this not make any sane person wonder if these metrics are remotely valid? How does it not make you ask yourself if a 15 P/E ratio isn’t the new 10 P/E ratio or whatever metric you use?

    The concept of “value” must be dynamic. It is not some static concept. Maybe the US stock market is just that much more “valuable” in the eyes of the holders for whatever reason (poor foreign competition, reduced access to US markets, etc). Everyone who is countering my point is basically arguing that we reside in some sort of static world where the valuations of the 50’s have to return some day, well, just because they existed at some previous point in time. That argument is not necessarily valid in a dynamic system!

  • Dinero

    But your hypothetical investor who stays with the expensive period would not have bought into the cheap values of the first period and so you can’t summate the two periods.

  • Johnny Evers

    Well, I think you are misrepresenting the value case.
    Even someone like Hussman has been in the market for most of the past 20 years. Valuations were better in 2002 and 2009. Saying the market is overvalued today doesn’t mean that you have been sitting on the sidelines for 20 years.
    Also some managers acknowledge that valuations are high, but they are still fully invested because they believe they will be able to get out in time.

  • Cullen Roche

    Not sure what you mean there. Tobin’s Q was historically low from 1973 until about the early 90s. 1993 is the year when it turned historically “expensive”. I presume that a user of this indicator would have been very bullish during the 70s and 80s and then turned more bearish during the 90s. Are you saying that assumption is false? If not, my time frames are totally appropriate….

  • Cullen Roche

    So what’s the point of using a “value” metric if you just ignore it? I am not sure what you’re arguing here. You’re basically arguing that you think these indicators matter, but that you can ignore them at the same time….That doesn’t make any sense.

    Someone using these indicators would be underweight stocks for much of the last 20 year period if they were adhering to the actual concept.

  • Dinero

    They would have, but to make a comparison of two strategies you have to compare what the returns are to someone who take valutions into consideration compared to someone who does not.

  • Cullen Roche

    I did exactly that in my example above! The person who takes “high” valuations into account in 1993 and alters their portfolio sees no benefit from doing so….

  • Johnny Evers

    Tough to debate with you when you make up my argument! I didn’t say you can ignore value.
    Investors who bought when valuations were good – in 2002 and 2009 — have done well. Investors who bought when valuations were poor — 1999, 2007 — have done poorly.

  • Dinero

    You did not do that.

    You did not do that at all.

    The question is –

    What would someone that did not use high/low valutions have done in the 1970s period.

    That is the question

  • Cullen Roche

    How do you figure that? The average Shiller CAPE, for instance, has been 16.5 since 1880. The lowest it got in 2002 was 21.21. No user of this metric would have been aggressively bullish during this period. In 2009 the metric declined to 13.32, but shot right back up to 20.32 by December of 2009. In other words, the market became extremely expensive within just a few months of buying. So you almost certainly would have reduced exposure in 2010 and going forward as the market has become more and more expensive. That doesn’t mean you had to be entirely out of stocks, but these metrics only had you on the aggressive side of the equity markets for a few years at most during the entirety of the last 20 years….

  • Cullen Roche

    Let’s do this. Compare it to an all equity portfolio. When the Shiller CAPE turns “expensive” in 1993 you move to a higher cash position of 20%. So:

    The all stock portfolio performance:

    1973-1993: 11.13% CAGR and 0.29 Sharpe ratio.
    1993-2013: 9.29% CAGR and 0.43 Sharpe ratio.

    The Shiller CAPE Method:

    1973-1993 (aggressively bullish period): 11.13% CAGR and 0.29 Sharpe ratio.
    1993-2013 (“expensive” period with 20% cash shift): 8.3% CAGR and 0.43 Sharpe ratio.

    In the second period when you thought the market was “expensive” your move to cash not only lowered your nominal return by a full 1%, but it resulted in no reduction in quantifiable risk. In other words, adhering to the concept that the market was “expensive” actually hurt your long-term returns and benefited you in no way of mitigating risk.

  • Dinero

    You are simply restating your original Hypothesis for the third time.

    The fact is, it is a fantastiacal “what if ” concept , where the imposible notion is entertained that the the subject of the analysis majcally changes their approch half way through the 40 year period of time.

    The correct way to aproach such an anaysis it is to compare the two different approaches over the whole 40 year period. And you have not done that.

  • Cullen Roche

    I established a hypothesis and then showed, with empirical facts, that changing your allocation due to this “value” methodology, would have hurt your returns. So the onus is on you to show that my hypothesis is wrong if you believe so. Simply saying I didn’t do a comprehensive enough study doesn’t achieve that. In essence, you keep saying that the “value” methodology works, but you have not shown any evidence that that is true.

  • Johnny Evers

    ‘That doesn’t mean you had to be entirely out of stocks, but these metrics only had you on the aggressive side of the equity markets for a few years at most during the entirety of the last 20 years.’
    That’s really the point. Stocks are on sale every few years and when they are, the 10-year returns are demonstrably very good.

  • Dinero

    I’m not saying that value metholidgy works, I’m joining in with the intellectual rigour that I see on the site.

    – what would somone not following value methodolgy have done in the 70s period.

  • Cullen Roche

    That sounds nice in theory, but it doesn’t work out that way in practice. For instance, you obviously need cash to allocate to new stock positions. So you’d want some dry powder for a year like 2009, right? Well, what happened. If you followed a basic rule of sell 20% stocks on a valuation over 20 on the Shiller CAPE and buy on any return to the average historical level of 16.5 (which is pretty lenient considering this isn’t even considered “undervalued) then you sold in December of 1993 and you didn’t reallocate that 20% position until….JANUARY OF 2008. And then guess what – you still got hit with the worst stock market crash of the last 20 years!

    I see no practical way to implement this indicator and no one here has explained it. All I see are vague explanations about “buy low, sell high”. Yes, that’s easy to do in theory and almost impossible in practice using the indicators as historical reference point….

    Trust me, if someone has some grand explanation for how to implement this then I am all ears, but I am saying, from my personal experience and analysis, that I don’t see the value here….

  • Johnny Evers

    Of course it’s hard!

    So are you saying
    a) you can’t put a value on the market
    b) it’s hard to make money even if you can correctly value the market.

    I really don’t understand how you can do anything in life if you don’t put a value on things, or, as most people do, just adopt the value judgements of the group.

  • Cullen Roche

    A little bit of both. Taking the “value” of something today and comparing it to the way people perceived its “value” 30 years ago probably doesn’t tell you as much about the items value as you might think. So yes, relying on a historical data set of “value” to invest will inevitably lead you astray.

    That doesn’t mean there’s no such thing as value. But I think it’s dangerous to think of “value” in relative terms.

  • Alberto

    Value in finance is always relative and is not a dangerous thinking. Mebane Faber has a lot of data that are essentially saying that a wide enough basket of international stocks with a CAPE of 9 is better than a broad national index with a CAPE of 26. This doesn’t mean the S&P is in a bubble but that a diversified basket of cheaper stocks are much less risky in the medium/long term with an expected higher return. Of course nothing is certain.

  • Skateman

    For all the talk of the Shiller P/E being high in 1993, there are a few things to keep in mind.

    1. It was high but not egregiously so. It averaged 20.7 for the year. The average from 1880-1992 had been 14.9. So the Shiller P/E showed overvaluation, but we weren’t talking about a 2-standard deviation event.

    2. Also, you can’t look at the Shiller P/E in isolation. Long-term profit margin trends can influence this ratio one way or another. From 1983-1993, margins had been a bit below average. This made the 1993 Shiller P/E look higher than it actually was. I don’t feel like crunching the data, but I suspect a Shiller P/E on normalized profit margins in 1993 was in the high teens.

    3. Fast forward 20 years and two things have happened. a) The Shiller P/E increased even more to 26, and b) profit margins over the prior 10 year period have never, ever been higher. Both of these factors made 20 year returns from 1993 look pretty good.

    That’s great, but to sit here today and say – “Hey, valuation metrics don’t matter! Returns could still be great the next 20 years just like in 1993!” – requires some heroic assumptions. First, that the Shiller P/E will expand again, this time to over 30, and that profit margins will once again expand another 50% (eye-balling it the 1983-1993 average was about 5% while the 2004-2014 average was about 7.5%). This is certainly possible. But it sure doesn’t seem like a wise bet to me.

    Anyway, just Google “Shiller full reversion forecast and realized returns” and look at the chart under “images”. It looks to me like Montier’s 7-year projections based on adjusted Shiller valuations are pretty damn prescient – and that’s just for 7 year projections!

    Finally, and I hate long posts, but I can’t help myself here – All of this new age crap about valuations not mattering too much as the market continues to levitate from typically sober market participants like Cullen, Ritholtz, Josh Brown, and the like is the kind of stuff that always happens closer to the top than the bottom – and I’m not bitter – My firm has been 100% long the whole way up as well (we’re not geniuses that’s just our mandate). That said, I suspect the market won’t break until Hussman finally closes up shop.

  • Dinero

    Someone not responding to indications of value would not have benefited from of the 70s value and in the 90s their returns would have been the same as for the “value” investor so over the forty year period they would have been outperformed by the “value” investor. On the other hand I appreciate the overarching logic of your macro economic approach.

  • Dinero

    Someone not responding to indications of value would not have benefited from the 70s value and in the 90s their returns would have been the same as for the “value” investor so over the forty year period they would have been outperformed by the “value” investor. On the other hand I appreciate the overarching logic of your macro economic approach.

  • Alberto

    My opinion is the market (worldwide) will implode when the US shail oil boom will be over. The real correlation is between stocks and US oil production which bottomed a few years before 2008. Then a new secondary boom starts because of 1) higher oil prices 2) ZIRP which allowed the drillers to embark in a debt bonanza to finance an extremely expensive production. But how good is that debt ? Will be ever payed back ? I don’t think so and the top is close when even the EIA which always wear pink glasses has recently admitted that after 2020 the US will have to buy much more oil in the middle east; but that oil is not there because OPEC oil peaked in 2006 and there are growing concerns that a decline amplified by the problems in Iraq/Lybia will start no later than next year. People working in finance don’t want to look at this, the smart people know why. This post is a good one:

  • Andrea Malagoli

    Agreed — in the end of the day, it is all about leverage lurking under “market miracles” … until the miracle ends because there is no corresponding real improvement in the real economy.

  • Cullen Roche

    I am not saying that valuations “don’t matter”. I am saying they’re not a tool that’s going to help you time the market. Does it scare me that market cap:gdp is almost as high as it’s ever been? You bet your ass it does! Am I going to significantly alter my allocations because of it? No.

  • Anonymous

    Value is dead — this is a popular attitude which if you’re a value/contrarian investor is probably a good thing.
    Here Cullen is basically saying that even though market cap/gdp is very high and he’s scared by this, he isn’t altering his outlook. It sounds as if he will let technical matters get him out of the market if necessary.
    I wonder if we can go as far as to say a stock no longer represents ownership in a company in which case the future return depends on future profits, but rather a derivative of sorts that is priced on behavioral factors.

  • Alberto

    timing the market is not easy nor difficult, is impossible, so it useless. The market is an unstable structure dominated by human behaviour which is irrational and unpredictable. Metrics can be used with other data, some of them not numerical, in order to make decisions. The more informations you have the harder the decisions because informations are never coherent. Dull people have little informations so they follow the herd and because the herd makes the market for a while, they succeed until the informations they don’t have kick them down the stairs. More informed people spend a lot of time struggling about how overvalued the market is grinding their teeths. So it happens that we are fooled by randomness or by ourselves from the very first day to the last one, so the best thing to do is avoiding to be too serious about economy, finance and expecially markets, switch off the computer frequently and spend more time outdoor.

  • WMO

    Ned Davis is basically data mining . Maybe just maybe overall market valuations have not really been tested to the upside just yet and we live in an economic environment where the future rates of returns being tolerated by investors justify much much higher valuations .
    Exactly who can say otherwise with any certainty .

  • Explorer

    The metrics fail to take into account the 30 year bull market in interest rates, which then converts to a 30 year bull market in capitalisation rates and PE’s but with a 30 year bear market in running yields.

    I like the analytical, data based approach of those who look at valuations and forecast returns eg Hussman, but it tells you nothing about:
    1. timing of falls in the market or the length of bubbles
    2, relative future performance against other asset classes
    3. extraneous events like war, natural disaster and competition from other countries eg China
    4. chances of policy missteps by government or the Fed
    5. the impact of barriers (Intellectual property creates limited monopolies – there is only one I-Phone) to entry on the likelihood and timing of mean reversion of earnings of large companies.