"Kee" Points with Jim Kee, Ph.D.

  • Market Highs Are Not Valuation Highs
  • Booms and Busts



Market Highs Are Not Valuation Highs

The big news release last week was the “Advance Estimate” for first quarter 2019 GDP, which came in at 3.2% (annualized), much higher than expectations. That’s the good news, but I would temper it by reiterating the surprising fact that one quarter’s GDP number has almost no predictive power as to what the next quarter’s number will be. Another item worth mentioning from last week’s news flow was the Wall Street Journal headline, “The S&P 500 and Nasdaq Hit Closing Records,” meaning indices are hitting their highest closings on record (WSJ). But you know what? So are corporate earnings or profits. Both of these variables trend upward over time, so they both hit all-time highs all the time. What confuses people (and the media reporting doesn’t help here) is that they hear or read, “The market is at an all-time high,” and what they think is, “valuation levels are at an all-time high.” Those are two very different things! The market is at an all-time high, but valuation levels are middle-of-the road. For example, the average price-to-earnings or P/E ratio for the stock market (S&P 500) over the past 30 years is 19.7. That means the market (investors) has been willing to pay $19.70 for each $1.00 of current earnings. The market pays a “multiple” of earnings because it is actually paying for current and expected future earnings. Right now, the market is trading at a P/E ratio of 19.23, so valuation levels are actually slightly below their 30 year average! What is an expensive market? Well, at the peak of the tech boom in 1999, the S&P 500 traded at a P/E multiple of 29.32. That’s 50% higher than today’s valuation level.

Booms and Busts

That doesn’t mean we won’t have recessions, corrections, and bear markets. But those are different from financial collapses or crashes. To again reiterate from prior Kee Points, research conducted by Nobel laureate Robert Shiller found that investors routinely overestimate the likelihood of severe crashes by a factor of 6. In other words, they believe that a market crash like 1987 or 1929 is about 6 times more likely to happen than it really is. Shiller’s work was published by the National Bureau of Economic Research (NBER), which officially dates recessions and expansions. The NBER also published research showing that stock market boom and bust episodes are also very rare. Researchers defined a market boom-bust as a period when the market went up by 100% or more in a 3-year period and then gave it all back in a crash. Looking at 42 stock markets around the world from 1900 through 2014, they found that booms were followed by busts or crashes only 10% of the time, which means that 90% of the time booms are not followed by busts or crashes. And yet many people consistently believe that a market crash is right around the corner. The best discussion of all of this that I have heard comes from economist Mark Dotzour, who retired from the excellent Texas A&M Real Estate Center. In a recent talk, Dotzour lamented the fact that most people look to the next recession through the lens of the 2007-09 global financial crisis. “That wasn’t a recession,” said Dotzour, “it was a financial apocalypse, and financial apocalypses happen maybe once in a lifetime!” Dotzour referenced his late father, who had lived through the Great Depression. It “stained his whole investing life,” as he waited for the next Great Depression, which never happened. My own father was the same, as I am sure were the parents of many Kee Points readers.