Why it’s wrong to fear pricey stocks

This raging bull market is still firmly intact

Those worried folks already baked those fears into stock prices. The only right time to fear valuations is when virtually no one does.

We keep hearing, “Stocks are too expensive. They can’t possibly keep rising.” We’ve heard it for years. Yet the bull market keeps running higher. It proves an age-old truth: When so many fear something in markets, you shouldn’t.

Why not? Those fearful folks did you a free service. They already baked those fears into stock prices. Markets always do that, price in common fears beforehand. Then they do what few expect. Markets live to surprise most people, most of the time. The surprise now will be stocks continuing to rise.

Naysayers remain undeterred. They’re insistent that stocks are too pricey. Their evidence? Usually a “valuation” called the priceto-earnings ratio, or P/E. It divides stock prices by last year’s corporate earnings. The higher the P/E, the more “expensive” stocks are seen as. It’s now 19.6 — way above historical averages. Conventional wisdom sees “expensive” as bearish. But always beware of conventional wisdom. It rarely works.

I’ve spent eons studying P/Es every which way. They predict nothing over one-, three- or fiveyear periods.

Many wonkish variations exist. I’ll spare you their jargonish details. None work. Since 1873, New Year’s Day’s, basic P/E topped today’s P/E 21 times. Stocks rose 13 of those years and fell eight. Not what P/E bears expect. Subsequent three-year annual returns were positive 16 times. Five-year returns? Positive 14 times. All of this is consistent with stocks’ tendency to rise roughly twothirds of history. It’s also fully useless for timing the stock market.

In all 143 years, any level of P/E, however high or low, successfully predicted simply nothing one year into the future. A complex but routine statistical tool called “R-squared” tests if one recurring phenomena possibly causes another. For P/Es, Rsquared shows zero possibility. Zero possibility over one, three and five years. The valuation myth continues because it feels right, not because it is right. Feelings are always dangerous in markets.

One newer and popular P/E variation is slightly predictive over 10-year periods. It was developed 20-plus years ago by Yale’s Robert Shiller and Harvard’s John Campbell. It divides stock prices by a convoluted vari- ation of the last decade’s average earnings, adjusted for inflation. It’s called the “Cyclically Adjusted P/E Ratio” — or CAPE for short. High CAPEs have some ultralong-term predictive power. They statistically explain roughly 10% of the next decade’s returns. But, again, they explain zip over the next one to five years. Because CAPE fits our common sense fear-of-heights mythology, it’s widely accepted as powerful. It isn’t. It’s been mostly wrong since being conceived.

Imagine if CAPE was perfectly right over all 10-year periods — and bearish — but the next seven years would see super-strong stock markets. What would you do? I’d guess you would want to own stocks now. Whatever happens over one to five years usually dominates most investors’ thinking. And P/Es simply aren’t predictive for those time frames any way you slice them. That’s also true outside America. Nor do other valuation metrics like Price-to-Book Value, dividend yield or Price-to- Sales (which I first popularized 33 year ago). So don’t sweat them now.

Think another way. Compare stocks to bonds, cash, etc. To measure relative value, roughly, flip P/E into an E/P. So, today’s 19.6 P/E is an E/P of one divided by 19.6, or 5.1%. That is also called the “earnings yield.” It’s what you would get forever annually if you owned the whole stock market and earnings never grew. And it’s huge compared with the 2.3% pre-tax return of 10-year government bonds.

Seen this way, stocks are cheap. E/P isn’t a timing tool either. But it does give you a relative handle on value.

The only right time to fear valuations is when virtually no one does.

With so many hanging hard to the notion that “expensive” stocks won’t rise — it makes rising stocks the most likely possibility. Bet on it. The bull market is firmly intact.