Is the Stock Market Overpriced?

The debate among market mavens these days is whether the stock market is over-priced or reasonably priced.  A good question if you are an investor or saving for retirement, in retirement, or have any interest in an IRA or 401K that offers optional investment alternatives.  That is probably a lot of us.

To reprise events of the last 4 or 5 years:  In 2008, the economy and the market turned down sharply, as a result of the financial problems brought on by the housing market and generally high individual debt levels.  The Federal government, and the Federal Reserve have taken extra ordinary measures to try to help individuals and the economy. Today the housing market has been declared to be recovered:  most of the Federal Government “Bail-out” money has been repaid and most of the Federal programs ended;  individuals and corporations have reduced debt.  But unemployment is still high, the economy’s growth rate is positive – but not very much so. Individuals and companies have reduced debt but investment and consumption rates are still low.  The Federal Reserve has reduced interest rates to near zero and kept them there in an effort to help the economy.  The unemployment rate has come down some, but not to the levels that one would like and the total number of individuals employed is down indicating that people have left the work force for whatever reasons.  In the meantime, the stock market seems to have recovered completely with both the S&P and Dow Jones  averages setting new highs.  So with the economy still in the doldrums, the question is: Is the market overpriced?

To try to find an answer to that it might help to take a hypothetical company that could represent an “average” public company and see how it has likely reacted to events since 2007.  To do this it is useful to look at some numbers that investors see routinely.  Keeping the arithmetic simple, lets assume our hypothetical company in 2007 had $100,000 in sales and netted after expenses 10% of that for a net income of $10,000.  Let’s assume that their income/share was $10 and the market price/earnings ratio (PE) was 15 making their market price $150/share.  The 2008/2009 downturn was pretty severe, but let’s assume that their sales were down a reasonably modest 6% for a total of $94,000.  Their expenses the first year would probably be down a little, maybe a couple of % or ~$88,000. So their net income would now be $6,000 or $6 per share.  If the PE multiple did not change, their share price would have been $90 or down 40% ( about what the market averages were down).

What happens next with most companies is that when earnings and sales are down, they start looking, in earnest, for ways to improve efficiency and reduce costs.  In good times, inefficiencies can creep in unnoticed.  If good times have gone on for 5 or 10 years without a serious effort to curb costs, my experience has been that an improvement of 10% is almost always possible.   However it may take 2-3 years and a reorganization of the work to get there.  So if our hypothetical company made cost reduction a priority over the next few years and managed to reduce costs by about 7% in that time, by 2011 say, even with flat sales they could have had expenses of $82,000 and net income of $12,000 – more net income that they had before the recession.  That would be $12/share and at a PE of 15 would be a stock price of $180/share – also higher than pre-recession levels.  Too high?

Before we attempt to answer that, lets consider earnings rates.  Conventional wisdom is that the reasonable expectations of company owners is to earn about 10% of investment.  Of course, most of us would like and maybe sometimes get more, but the “risk premium” over investment grade bonds is usually considered to be 4-5% .  Investment grade bond rates are “normally” in the 5-6% range.  A corresponding flat income PE would be 10.  A higher PE would indicate a market expectation of income growth.  So a 15 PE might indicate a 5% growth expectation.  A 15 PE for the S&P has been about the average over the last 20 to 30 years.  The $12/share is about 5% per year higher than $10 per share of 5 years earlier.  So what’s the problem?  or is there one?

The concern is that austerity programs can for most industries only do so much.  With most industries, for the income increases to continue, the sales numbers have to grow.  Without sales growth companies aren’t going to be able to maintain the income growths of the last few years.  The slow growth rates of the overall economy is not encouraging.  With fewer people in the work force and the baby boomers retiring in greater numbers over the next few years, there is a real question if we’ll see the growing consumer spending at the rates we’ve seen in the last 30 years.  The Fed has apparently had little success with the current policies and keeping low-interest rates.  The low rates hurt retiree income and companies aren’t going to increase investment if sales aren’t growing.  With dividend yields fo many companies being higher than bond yields (and certainly higher than bank CD yields), there is also the likelihood that some people are increasing investment in stocks to keep income levels up.  It’s possible the Fed’s policies are hurting more than helping.  With more people retiring and a declining work force it may be that growth may be in the 1-2% for the some time to come.  This could result in the average PE going to 11 or 12.  At a PE of 12 our hypothetical company stock would drop from $180 to $144 or 20%.

Are stocks overpriced?  Based on today’s data, it would appear so.  But the market tends to look ahead – expectations count.  It’s still possible that the US economy may gain strength and return to a 3%- 4% growth level.  But we are also in and interdependent world.  If Europe or other parts of the world regain momentum, many companies with international ties could return to historical growth prospects.   Or some combination of U.S. and world economies could get us there.

So are we overpriced?  Maybe, maybe not.  Just because history has supported corporate growth rates of 5% doesn’t mean that it can’t change, but it will take some time to change people’s mind-set and expectations.  On the other hand, it may too soon to say that we won’t pick up to historic levels.  And it is comforting to think that we are not much above historic levels, even though the economy hasn’t seemingly recovered.  There is an argument to be made both ways.  But if the economy doesn’t pick up soon, I would expect at least an interim correction.

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About tjc13

BE - Chem Engineering, Vanderbilt Univ, MBA, University of Tulsa - Worked for an energy and chemical company for many years and then started a management consulting business working for both for-profit and not-for-profit organizations.
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One Response to Is the Stock Market Overpriced?

  1. Pat Cain says:

    Greetings Tom. Need a job? Great analysis. The market is probably fairly priced at the moment. But as you said the market looks forward. There are several positive developments which could be driving market optimism 1. Potential to be off foreign energy in the next several years. 2. America is beginning to reindustrialize because the low cost of labor is disappearing in the developing world. 3. Baby Boomers retireing peaks in 15 years. When they do retire, boomers will likely choose return on savings as opposed to consumption of savings. Therefore dividend paying stocks should do well. However it looks like the overdue correction has started. Should be used for buying?
    Pat Cain

    Like

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