If you follow the stock market you have probably heard numerous times that stock prices are currently expensive. I myself am guilty of saying this on many occasions. But what does it actually mean when someone says that stocks are expensive?
Well firstly, it refers to the stock market in general. Obviously not every single stock trading publicly is necessarily expensive. You may be able to find pockets of value in the market. But when someone says stocks are expensive, they are generally referring to the market as a whole so for the Australian stock market, think the All Ordinaries Index (All Ords).
The All Ords captures the top 500 stocks on the Australian Stock Exchange (ASX) and simply looking at a chart can give you an indication that the market is expensive. If you set the chart parametres to show you a 10+ year view of the All Ords, you will see that we are near the summit.
But the chart doesn’t actually represent whether the market is expensive or not. It does show that stock prices are currently high, but to say something is expensive means that the price you are paying doesn’t represent good value. To better determine if the market is expensive, we need to look at the price-to-earnings ratio (P/E ratio).
The P/E ratio of a market is calculated by taking the total price of all stocks in that market (or index) and dividing it by the total earnings. By doing this, you are getting an idea of how much you are paying for the earnings produced or, put another way, how long it would take for the earnings to match the current market price.
The P/E ratio of the ASX is currently trading around 35 and the long-term average is around 15, normally fluctuating between 10 and 20. This tells us that people are currently paying a lot more for company’s earnings than they traditionally have, concluding that stocks are currently expensive.
Now there are many other indicators of the value in a market, like the famous Buffett Indicator which compares market capitalisation to GDP, however for the purpose of this exercise we are going to focus on the P/E ratio because it is widely accepted as one of the mainstream indicators of value.
But is a high P/E a reason not to buy any stocks at the moment? Well….no.
A high P/E ratio is definitely a reason to be cautious, but we have to understand why the P/E is high and, in this market, that boils down to interest rates.
In an environment where you can’t earn a real return on cash, bonds and other defensive assets, people are forced to pay a higher price for those assets like stocks which are still giving you a decent real return after inflation (even at these high levels).
However, the biggest risk to buying stocks at the moment is that intertest rates could rise which would makes defensives attractive again and cause some investors to switch assets out of the stock market and into cash and bonds. This would cause stock prices to fall, and the P/E would pull back along with it.
Knowing all of this, what are we doing at the moment in our portfolios? Well, we still retain exposure to stocks in our portfolios – that’s not going to change! But we have diversified somewhat away from stocks, particularly large cap stocks, and into other areas.
This includes an increased exposure to the small and mid-cap space. These companies have a lot better potential to grow future earnings, so a higher P/E ratio is justified. We have also increased exposure to alternative assets such as real return funds and market neutral funds, and increased our exposure to infrastructure.
So while it is prudent to be cautious of stocks in this market, there is also a very real risk to sitting on the sidelines. Like John Maynard Keynes said, “the markets can remain irrational longer than you can remain solvent”.