What is an investor to do in the face of mounting evidence of an overvalued market?

This question was posed by a handful of clients this week in response to last week’s blog highlighting that investors currently are downplaying risk; that several valuation measures are flashing caution warnings; and that investors should be prepared for a pullback in the near-term


This week we further examine valuation measures and how they should be understood. We examine the role of the Fed in manipulating stock prices, knowing full well that markets can climb still higher despite extended valuations.  For the cautious investor, with equities looking less attractive, reducing equity exposure over a period of time makes sense.  Finally, we examine how the current period bears some resemblance to the mid-1990s.

Overvaluation:  The Evidence.  The Economist offers a perspective on the cyclically-adjusted price-earnings ratio (CAPE) devised by Robert Shiller of Yale—a valuation measure–which averages earnings over a 10 year period.  It also presents another valuation measure—the Q ratio—which compares share prices with the replacement cost of companies’ net assets.  Both measures together suggest the market is overvalued.  However, it is noted, the ratios are not very good short-term indicators, because there aren’t any good short-term indicators.  The sensible investor will use the measures as a long-term guide.

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An interview with Jeremy Grantham. According to Jeremy Grantham of GMO, the Fed clearly is manipulating stock prices.  He thinks the market is going to go higher because the Fed hasn’t ended its game, and it won’t stop playing its game until we are in old-fashioned bubble territory and it bursts, which he suggests usually happens when the S&P 500 is roughly 25% above where we are now.  He also asks the question: why would you want to get an advantage from the wealth effect when you know you are going to have to give it all back when the Fed reverses course?

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Divesting When Discomfited.  Of the same firm as Jeremy Grantham, Ben Inker indicates that, as equities become less attractive, a conservative stance is warranted. GMO is in the process of selling down equities slowly over the coming year, and expects to be holding significantly less by the end of 2014. (Second article in the link)

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A Look Back at the 1990s.   Liz Ann Sonders, Chief Investment Strategist at Charles Schwab, notes similarities between today’s market environment and the one in the mid-1990s, and produces a mountain of supporting documentation.  She believes we may be entering a period similar to the mid-to-late 1990s, when the stock market and volatility both rose for an extended period (the only time in history). She sees valuations bearing a striking similarity to that era (rising, but not in bubble territory).  We likely are in a more mature stage of economic and market cycles, a phase when individual investor participation heats up.  She notes the ultimate melt-up in the markets did not end well, as we all know.  A better scenario this time would be for the market to continue pacing the mid-1990s market, but without the blow-off top in 1999-2000.

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We hope you enjoy reading these articles along with us and hope you find them informative.  Please forward this to your family and friends.

J. Mark Nickell & Co.

Disclosure – The articles mentioned in This Week with J. Mark Nickell & Co. are for information and educational purposes only. They represent a sample of the numerous articles that the firm reads each week to stay current on financial and economic topics. The articles are linked to websites separate from the J. Mark Nickell & Co. website. The opinions expressed in these articles are the opinions of the author and not J. Mark Nickell & Co. This is not an offer to buy or sell any security.  J. Mark Nickell & Co. is under no obligation to update any of the information in these articles. We cannot attest to the accuracy of the data in the articles.