Is the Market Overvalued? Depends Who You Ask

Critics of index investing often argue that the strategy is not sensitive to valuation. They feel that a simple strategy of buy, hold and rebalance is folly: there are times when the market is cheap or overvalued, and it makes sense to shift toward or away from equities accordingly.

It’s hard to argue with that principle. There are certainly periods when markets appear frothy and others that look like excellent buying opportunities. The problem is, whose valuation should you believe?

On April 2, Vanguard’s chief economist Joseph Davis went on BNN and said that valuations are right around their historical averages, so expected stock returns over the next several years should also be near their historical averages, which in the US is about 9% a year.

Three days later, The Globe and Mail ran an article about Prof. Robert Shiller’s method for valuing the market. According to Shiller, the earnings yield of the S&P 500 is currently 4.5%, compared with the historical median of 6.3%, which means the market is significantly overvalued. This translates to expected returns of 2.6% annually over the next 10 years.

What is the average investor to make of this? Of course, investment firms (even Vanguard) have a vested interest in being bullish on equities—I get that. But traditional valuation measures are easily quantified: the trailing P/E ratio of the S&P 500 today is about 16.2, compared with the historical average of about 15. So it’s indeed pretty close to average.

And while Shiller is an academic with fewer conflicts of interest, that doesn’t necessarily mean he’s right. While his predications have a good track record, his data were also saying equities were overvalued last fall, yet since October the US market is up about 25%. If you made a tactical shift away from stocks based on his valuation, you missed an enormous rally: 2012 saw the best first quarter for US stocks since 1998.

Diversify, rebalance and stop guessing

This is my concern about making tactical moves based on valuation, which is really just a form of market timing. First, you need to base your actions on data that can tell conflicting stories. I don’t know how you decide which criteria to use with any confidence, since all of them will be right during some periods and dead wrong during others. (Ken Fisher’s The Only Three Questions That Count includes a lengthy discussion about why P/E ratios don’t always have predictive value.) Then you need to execute your strategy consistently and unemotionally. I suggest that’s much easier said than done—especially after a couple of your moves backfire.

Simply owning a broadly diversified portfolio can go a long way toward making all of this less important. If you’re holding government bonds, corporate bonds, real-return bonds, stocks from around the world (with a mixture of value and growth, large and small), real estate and several currencies, chances are that there will always be both overvalued and undervalued assets in the mix, whatever yardstick you want to use. And a disciplined, rules-based rebalancing strategy is a self-correcting mechanism that ensures no asset class has too much or too little influence for very long. It’s not a valuation tool, but it does help you build in a measure of “buy low, sell high” without resorting to forecasts.

Update: Couch Potato returns

I have just uploaded the up-to-date returns data for the Couch Potato model portfolios with a new feature. Many readers asked me to include returns for the TD e-Series funds, and I’ve obliged. As it happens, this has the added benefit of allowing us to look at longer-term returns for the Global Couch Potato, since the e-Series has been around much longer than most of the ETFs on the list. As of March 31, the 10-year annualized return of the Global Couch Potato (using non-hedged funds for the US and international components) is 4.17%. The three-year return is 9.99%.