In the previous post, I made the point that US stock market valuation isn’t as high as a cursory glance at traditional P/E measures might imply. Adjusted for inflation, valuations actually look more “median” than anything. But I also don’t think US market valuations are currently attractive. And some of the arguments I’ve seen about attractive valuations are just flawed.
Typically it goes something like “the P/E may be higher than the long-term average, but compared to the past 20 years it’s not high at all.” And this is true. For example, over the past 20 years, the CAPE has averaged somewhere around 25x — not too far from where it stands now.
The comparison doesn’t look alarming unless you compare the current 26x CAPE reading to the long-term average of 16x — that implies significant overvaluation. But some will argue “the long-term average may be lower, but long-term averages are irrelevant because today’s market is different.”
Markets have certainly changed over time, but what constitutes “high or low valuation” has actually remained fairly consistent. Nonetheless, the argument always surfaces that somehow, someway, something has permanently changed the market’s perception of “expensive.”
But time and again that thinking has been wrong. The fact is every major US equity bear market has started with high, double-digit P/Es (expensive), just as every major bull market has started with low, single-digit P/Es (cheap). Regardless of when in time or what the circumstances, this has been consistent throughout history.
The point is it’s just flawed to “cherry-pick” a time period for making valuation comparisons. Of course, valuations don’t look high if you only compare them to a period during which valuations have been abnormally high! The whole purpose of using a long-term average is to smooth out abnormalities to prevent skew and bias. Convince yourself of otherwise and you’re only fooling yourself.
Victor K Lai, CFA
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