Tuesday, October 08, 2013

Is the stock market overvalued?

According to a recent survey of company CFOs, nearly half believe that the stock market is overvalued. At Wade Financial Group, we have the belief that what goes up, must come down. We’ve seen 50 percent drops in the stock market twice in the past 15 years—in 2000 and 2008. We’re now riding a 5-year rise in the market…which means that we may be poised for ugly results over the next 5-10 years.

Let’s look at the Shiller Price-to-Earnings ratio, commonly called the Shiller P/E ratio. This is an equity valuation that divides the market price per share by the earnings per share. Here's a chart from GuruFocus.com, looking at the ratio.

At the time of this writing, the Shiller P/E ratio is 23.6 (the red line), which is higher than the average of 16.49 (the gray line). What does that mean? Company stock prices are high compared to company earnings.

Global investment companies like PIMCO look at that; PIMCO just this summer released a forecast that annual returns will be in the area of 4.2% over the next five years, and a dismal 1.5% over the next 10 years.

As we mentioned before, we’re riding a 5-year rise in the markets…which means we may face a possible correction that will hurt investors:

What happens when you buy at the peak? Let’s look at history. What would you have earned if you bought stocks at the peak of the tech bubble in 2000 and just held them until today?
  • 10.5% total return over 13 years
  • 0.81% per year—before fees and taxes
If you bought today, my feeling is you would have the similar returns over the next 5-10 years.

What can investors do?
If you’re looking for income, there are a few areas I am recommending to my clients:

  1. Carefully selected high yield bonds
  2. There are mutual funds where you can buy $1 worth of tax-free muni bonds for 0.85 cents.
  3. Carefully selected dividend stocks in US
  4. Consider selling covered calls for a more reliable income stream.
  5. Global bonds
If you’re looking for long-term return, I would consider emerging markets, which have been beaten up badly in the past few years. We've blogged before about the opportunity we're seeing with emerging markets. Their Shiller P/E ratio is in the 10-15 range—or below average. While there are no guarantees in investing or in life, this may signal a higher return over the next 5-10 years.

--Jerry Wade, CFP®, CFS
Chief Investment Officer, Wade Financial Group

UPDATE: Jerry was interviewed on this subject on WCCO radio, on Tuesday, October 8. Listen to the full audio of the interview.

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