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:

• In November of 2009 Smithers said equities were 40% overvalued (see here also).
• In December 2010 Smithers said equities were 70% overvalued.
• In March of 2012 Smithers said equities were 50% overvalued.
• And now we hear the citation about an 80% overvaluation.

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….