How Do We Know When Stocks Are Overvalued?

Beyond Buy-and-Hold #20

By Rob Bennett

There never can be a correct consensus that stocks are overvalued.

Yes, I mean that just the way I said it. I?ll even say it again.

There never can be a correct consensus that stocks are overvalued.

Say that most analysts come to believe that stocks are overvalued. That would cause them to sell stocks. That would bring prices down. So much for the overvaluation!

There can be overvaluation, of course.

But only when most of us don?t see that it exists.

Overvaluation is by definition a hidden danger. It can destroy us. But we cannot prepare for it. Once we sense a need to be wary, it is gone. Once our wariness fades, it returns. Overvaluation is like your shadow. Move in close to get a good look at it and it moves out of sight.

The implications are huge.

Forget about counting on the experts to warn you when valuations have gotten out of hand. If most experts are saying that overvaluation is a problem, it is a logical impossibility that they are right. It?s only when most experts do not see a problem that there really is a problem. Once you take that reality into account, it starts to seem sort of dumb to keep up with what the experts think, doesn?t it?

Cutting through the fog to find the truth

There are three solutions to the problem.

One, you could give more credence to minority viewpoints. It is not possible for a majority of experts to be aware of overvaluation and for it to continue to exist all the same, but it is possible for a minority of experts to be aware of a genuine overvaluation problem.

Two, you could turn to non-human sources of information to learn when overvaluation is a problem. The reason why the majority can never be aware of an overvaluation problem is that humans act on what they know. Once the majority knows it needs to act, the problem causing them to act disappears. But P/E10 (the price of a broad index over the average of the last 10 years of earnings) is a number, not a human. P/E10 can accurately report when there is an overvaluation problem so long as not too many experts pay attention to P/E10.

Three, we could teach everyone about P/E10 and what it tells us about the value proposition associated with stocks. If all investors lowered their stock allocations when prices went too high (because they understood that that causes going-forward returns to be low), we would never again see significant overvaluation (the sales would pull prices down and returns up). In that case, there would never again be a consensus that stocks were overvalued. But at least this would now be for a good reason — there really would never again be overvaluation.

All of this is paradoxical. That drives people nuts. People want stock investing to make sense. Paradoxes disturbs us.

Sorry.

The REAL issue we need to focus on

It is not my reporting on these realities that people should find disturbing. The truly disturbing thing is overvaluation itself. Overvalued stocks are mispriced stocks. Just about all of us have some of our retirement money in stocks. So we all should want stocks always to be priced properly. We shouldn?t be willing to tolerate overvaluation.

Why do we?

Because we deceive ourselves into thinking it is not there. When there is a consensus that overvaluation is not a problem, it almost always is one. Why? Because it is only when most of us are concerned about high prices that prices can be kept reasonable. Once we stop worrying about overvaluation, it becomes a looming threat to our financial futures.

Are you worried about overvaluation today?

If you are and if most of your friends are too, you should forget about it, there?s no need for concern. If neither you nor any of your friends are worried, be afraid, be very afraid.

Do you see what is going on here?

?Overvaluation? is a word we use to describe the extent to which we are telling lies to ourselves about the value of stocks. It?s like the old joke where you tell someone ?everything I say is a lie.? That cannot be so, can it? If everything you say is a lie, the statement ?everything I say is a lie? is a lie and the reality must be that you always tell the truth.

The true price of a stock index is never the nominal price, the one that is quoted in the newspapers. The true price is always the nominal price adjusted for the extent to which we are telling ourselves lies about the price. P/E10 is the metric that tells us how much of a lie we are telling ourselves at a particular time. Subtract for the amount of overvaluation present, and you know the true price!

University of Chicago Economics Professor Eugene Fama said that the market price is always the best possible price that could be assigned. He almost nailed it. The price as adjusted for the effect of overvaluation or undervaluation is always the best possible price.

That means that the unadjusted nominal price (the price that Fama says is always right) is always wrong!

Oh, my!

Rob Bennett often writes about how the best investing strategy. His bio is here.

( Photo by bikehikedive )