What does "the market is overvalued" actually mean?

[disneysteve]

I often hear people, both here and in the media, use the expression that the market is overvalued or the market is undervalued and it is generally used as a justification for buying or selling stock. I'm curious what your thoughts are on that terminology.

I think the problem is that saying "the market" is over or undervalued is that it treats the entire stock market as if it were a single investment rather than thousands of individual companies in multiple sectors and industries. They don't all perform in lock step with one another.

How many times have we heard that the S&P 500 has had a zero return over the past 10 years? While that's true, I don't see that as a valid reason to pull all my money out of stocks and load up on bonds or precious metals or real estate. Why not? Even though it is true that the S&P 500 has had a zero (or even slightly negative) return over the past 10 years, that isn't the entire stock market. I personally own two stock mutual funds with 10-year average annual returns of between 9 and 10% so obviously "the market" didn't all suffer the same fate.

I think it would make sense to say a particular sector or industry might be overvalued, like during the tech bubble a number of years ago. When that happens, it might be prudent to trim your holdings in that area and shift money into other sectors with better prospects. To say the market in general is overvalued, though, just doesn't seem to make sense to me.

[feh]

When they say that, I think they are generally referring to the market as a whole (average P/E ratio), which is relevant to individual investors if you're buying index funds.

[disneysteve]

When they say that, I think they are generally referring to the market as a whole (average P/E ratio), which is relevant to individual investors if you're buying index funds.

Even then, though, there are lots of different index funds that track various sectors of the market. Sure, there are total stock market funds but there are also indexes that track only large company growth stocks or small company value stocks or retail stocks, tech stocks, health care stocks, global stocks, international stocks in certain countries, etc.

[Broken Arrow]

This is going to be interesting, but it's also a great question because I know I've made this overly-simplified statement many times as well.

Long story short, everyone has an opinion of what "fair market value" is suppose to be. And though it could be used to refer to something individual, all the way down to a single stock, it can also be used to generalize the entire stock market as well, which is the case here. So when something is higher than the anticipated "fair market value", then it is considered over-valued, and vice versa.

As for the generalization about the stock market, I fully agree with you! The stock market is like the ocean. It only looks homogeneous from a distance, but it's a vast entity that, once you look below the surface, you'll find a vibrant variety of all kinds of life. If you look hard enough, I'll bet you can find a stock that is linked to just about every kind of asset class imaginable.

That is one of many points I didn't bring up in *cough* er a different thread because it has already gotten out of hand and I didn't want to exacerbate it....

[disneysteve]

That is one of many points I didn't bring up in *cough* er a different thread because it has already gotten out of hand and I didn't want to exacerbate it....

I almost posted this conversation to that other thread but decided it would be a good conversation by itself.

[EEinNJ]

I would say the "market is overvalued" is a contextual remark. That is, broad market valuations are partly based on P/E, but the market is also forward looking. So in our current case, the valuations might be based on overly optimistic expectations of economic recovery. Commentators may look at other measures such as unemployment, consumer spending, etc, and postulate the future ain't what it used to be.

[Broken Arrow]

I almost posted this conversation to that other thread but decided it would be a good conversation by itself.

Yes indeed! In that case, let's just go straight to the "The Man" on this subject matter: Professor Robert Schiller of Yale University's department of Economics, and yes, the same Schiller of Case-Schiller Home Price Index fame.

Now, this man is probably 100 times smarter than I am, so I doubt I can actually summarize him easily.... but I'll to give it a shot. Basically, he believes that while the short term and even mid term stock market is not efficient, given enough time, the long term market can be. Which means, despite the erratic swings in volatility, the market will always try to "regress to the mean", which is what is meant by "fair market value".

Now, the mean changes all the time, but basically, if the current market level is above this mean, then it's over-valued, and if it's below, then it's not. There are plenty of ways to go about trying to figure this out, but here's his take on it.

I'm going to be blunt here (because I do have Foot-in-Mouth Disease ), but what Scanner and I have talked about here is a poorly constructed and fairly misguided notion of what Schiller is attempting to teach and help us understand. However, that still doesn't mean the current, short-term market is not over-valued.... I don't say that to defend anyone, but if you do agree with Schiller's valuation methods, then I believe the current overall market is running at about 10% to 15% over the mean.

Of course, as much as I respect Professor Schiller, I'm also a fundamentalist at heart. So, I can't just accept that the market is over-valued simply because "some number is greater than some other number". Unfortunately, the more I looked around, the more I realized that the fundamental story seems to agree with this over-valuation business. So... as a trader, I have to face the ugly fact that it is indeed, for the moment, over-valued.

But I also can't stress this enough: For passive investors, I wouldn't even worry about any of this. If your asset allocation is correct for you, then just keep chugging along. For traders though, it's time to take some off the table and cover your positions.

[disneysteve]

I would say the "market is overvalued" is a contextual remark. That is, broad market valuations are partly based on P/E, but the market is also forward looking. So in our current case, the valuations might be based on overly optimistic expectations of economic recovery. Commentators may look at other measures such as unemployment, consumer spending, etc, and postulate the future ain't what it used to be.

I understand all of that. I guess I'm just not sure what significance that judgment has if it is so overly broad. The total stock market might be overvalued but individual sectors and certainly individual stocks might be just fine or even undervalued. Do the pundits scare investors out of the market by making such sweeping generalizations?

As I've said, I have stocks and funds that have lost money in the past couple of years and I have stocks and funds that have made money in the past couple of years. I'm not sure I see the value in looking at the total overall market and trying to assign a fair value to it.

It is like saying that a certain store is overpriced. It may be true that certain items at that store are priced too high but there can still be things at the store that are a good value. Since no shopper walking through the door is going to buy every single item the store sells, the general comment that the store is overpriced isn't really meaningful.

[Broken Arrow]

Again Steve, I'm with you. That's why I'm still in the stock market, because simply being in there doesn't necessarily mean you can't make money. But you do have to be specific with what you buy so you can hone in on the ones that stand the best chances of making money.... I treat the bond market the same way as well.

I was long during 4th quarter 2008 as well, and though that was probably a really dumb thing to do, I did walk away with a huge gain.

[Scanner]

I tend to look at things simply as per the other thread. The average S & P 500 is about 18.3 Price to Earnings Ratio. So, you buy Vanguard's S & P 500 (arguabley the most popular fund ever bought). . .that's what you are buying shares of.

Would you buy a company for 18X what a company earned?

Broken arrow rightfully pointed out in my thread - "Maybe", if let's say it had a lot of assets (inventory, real estate) but IMO. . .those tangibles are only worth so much. Maybe in the case of an energy co. like Exxon and it's sitting on 1 million barrels of oil at any one time. . .okay. . .but even that's only worth so much.

If I have to seize all of Walmarts tangibles and liquidate them, I am sure in such a "fire sale", as a shareholder, I am only going to get $.20 to $.80 on the dollar. In fact, that's probably generous because as we all know, when companies go under, stockholders, esp. common stock, are paid about $.01 on the dollar. Whether accountants and analysts figure this into what a company is worth in the "Total market value", I don't know. I personally don't think so.

All I know is the market should not be up 50% one year, down 60% the next, up 40% the next year. Commodities - maybe. Stock and RE market - no. I don't understand it and therefore, don't want to invest in it for the time being until I figure it out more and at least understand it. The volatility to me would indicate risk (risky funds such as my Janus are volatile). Here's the interesting thing about taking risk - you can win big. . .or something we tend to forget - we can lose big.

For those of you that understand it in any other capacity. . .god bless ya.

[Broken Arrow]

If I have to seize all of Walmarts tangibles and liquidate them, I am sure in such a "fire sale", as a shareholder. I am only going to get $.20 to $.80 on the dollar. In fact, that's probably generous because as we all know, when companies go under, stockholders, esp. common stock, are paid about $.01 on the dollar. Whether accountants and analysts figure this into what a company is worth in the "Total market value", I don't know. I personally don't think so.

While it's true that, during a fire sale, you typically get only a fraction of your tangible asset's true worth, that also assumes if it a company actually bellies up. Please remember that Wal-mart actually made profit(!) through the worst of this recession.

Again, I feel like you're generalizing the risks of stocks and applying that to the whole stock market, and the point of this thread is trying to show that the stock market shouldn't be generalized like that.

[disneysteve]

Again, I feel like you're generalizing the risks of stocks and applying that to the whole stock market, and the point of this thread is trying to show that the stock market shouldn't be generalized like that.

Exactly. Lehman disintegrated but WalMart made money. I made a nice profit on Bank of America stock last year while some other banks went totally out of existence.

I'm not sure how the broad generalization of the overall market is actually meaningful to investors.

[Scanner]

I was only using Walmart as an example.

I probably shouldn't have used that icon as an example as it's practically unimaginable that Walmart would ever collapse.

Using them as an example is like using an icon like Bear Stearns or something. Somebody like them would never go belly-up, right?

[Broken Arrow]

Using them as an example is like using an icon like Bear Stearns or something. Somebody like them would never go belly-up, right?

I've never denied that stocks can't belly up either. But that... once again.... goes back to what I said about diversification or valuations. You do one or the other so you can avoid pitfalls like that.

I've also pointed out that the number of companies that actually did go belly up on the stock exchange is a fairly small minority.

[Scanner]

Okay. . .yes. . . I concede - the # of stocks that go belly up is a minority, small minority.

How about the number of stocks that don't really go "belly up" but basically get "vetted" out as to where, "Gee, you aren't worth as much as we all thought you were worth? I think we were all on a buying spree. Oops."

Can the almighty diversification immunize you from that?

Do you see my point? You have people. . .saying, "Stuff my money somewhere. . .anwhere where it outpaces inflation. Either they (do-it-yourselfers) or a financial advisor says, "I know. .. let's buy stocks [mutual funds]. That's a good place."

What do you think the consequence of that is?