Do valuations matter?
As a value minded investor, I pay attention to how much I pay for an asset. There are several different ways to calculate a value depending upon the asset. In the case of equities this may even vary be industry. When looking at markets as a whole, a simplified method is likely the best. The two that I favor for this exercise is the price to sales and Shiller P/E. I like price to sales because sales are much harder to fudge than earnings.
I like the Shiller P/E due to it’s predictive nature albeit with about a 7 year lag.
Each of these measures are indicating stock market valuations that are at the highest levels we have seen in history with the lone exception being the late 1990’s dot com bubble. So what. Valuations have been above the average everyday since 2009 and this has not stopped the markets advance. We have now registered the longest bull market on record. This occurred as valuations have moved from fair to very highly valued. There is not a valuation level that consistently triggers a top in stock prices. It is therefore not useful when trying to predict when a market will top.
What are valuations good for then? At the market level it gives an indication of the demand for a dollar of earnings. If the demand is greater than the supply, the price and valuation will rise. This mechanism works both ways. As the demand declines, the valuation contracts and price can decline. The main use of valuation is not to predict market tops and bottoms but to indicate what level of risk (high or low) is built into the prices.
The current valuation levels would require a 50% decline in price to hit the long- term averages using either metric. It may also be resolved with a prolonged period of level prices while earnings and sales catch up to the current price level. History would tell you that the former is more likely than the latter. Valuations will matter when the bull market exhausts itself and investors eye how high they have climbed.