Are shares overvalued? In a word, yes. By every traditional metric they are overvalued. Ever heard of Warren Buffett? The fourth wealthiest man on the planet with a net worth of approximately $80 billion USD (source: https://www.forbes.com/profile/warren-buffett/#d93356d46398). How did he make his money? Buying shares. An indicator that has come to be known as the ‘Buffett indicator’, stock market cap vs GDP is at an all-time high. Buffett evidently remarked that “it is probably the best single measure of where valuations stand at any given moment”.
The go-to metric for how cheap or expensive share-markets are is the price-earnings ratio. For either single stocks or the stock market as a whole. The P/E tells us how long, based on current profits, one is willing to pay as a multiple of profits. For example, in simple terms, if a company is valued at $10 per share and makes $1 profit the P/E will be: $10 (share price) divided by $1 (profit) = 10x. Hence, based on current profits this company would take ten years of current earnings (10 years x $1), as a multiple of profit. As a rough rule of thumb, average P/E’s across stock markets are around 14 or 15. So what are markets trading on now? The S&P 500 (largest 500 stocks in the US) is trading on a P/E of 27.76 (source: https://www.bloomberg.com/quote/SPX:IND) . The tech-heavy Nasdaq is trading on an extraordinarily high P/E of 96.87 (source: https://www.bloomberg.com/quote/CCMP:IND). The ASX 200 is trading on 36.87 (source: https://www.bloomberg.com/quote/AS51:IND).
There is almost a two-tier stock market – with ‘growth’ stocks performing extraordinarily well in recent times. Growth stocks are stocks that are growing quickly, they may make low (or no) profits as money is being reinvested in order to expand. Typically they will pay very small or no dividends A ‘value’ stock on the other hand is a stock that is trading at a relatively lower valuation, tends to trade at lower price-earnings ratios, pay higher dividends and have stronger balance sheets. Value stocks tend to be more ‘boring’ and unexciting than their exciting growth stock counterparts. However, it is expected that, in downturns, the value stocks will perform better as there tends to be a flight to safety.
An example of a growth stock is Tesla. Tesla is valued at $680 Billion USD (source: https://www.bloomberg.com/quote/TSLA:US). Tesla is valued at more than twice Toyota’s $250 Billion USD valuation despite Tesla producing around 500,000 vehicles in 2020 and Toyota almost 10,000,000 vehicles. Tesla trades on a price earnings (P/E) ratio of 359 versus Toyota’s P/E of 12. The multiple of over 350 for Tesla and less than 13 for Toyota…is quite extraordinary. For investors in Tesla to be proven right at these share prices, the profits of Tesla must rise dramatically for a very long period of time – and would assume the growth rate remains fantastically high – however, the more attractive a market niche is – the more competitors will attack that niche. Personally, I would be more inclined to buy Toyota at a conservative 12 x than Tesla at over 350 x!
How to invest when interest rates are low (and share valuations are high)?
Well, this is where you give me a call – Mike Beal, your Sunshine Coast Financial Adviser. It’s undoubtedly a very tough environment to invest currently. However, there are some strategies that I think can help preserve wealth – particularly if there is indeed a correction or crash. Here’s some things I think people should look at now:
- Diversify! Now, more than ever, it is very important to diversify. The more you’re diversified, the more you are protected
- Look at long-short funds. Some funds will allocate a portion of their capital to ‘shorting’ what they consider to be very expensive shares, thus if there is a correction they will profit from these ‘short’ thus helping to protect the portfolio
- Keep some of your powder dry so that you can invest more if there is a correction and more attractive valuations to take advantage of
- Look at fixed interest options that are not subject to duration risk
- Use dollar cost averaging to decrease risk
- Examine value-oriented managers
- Invest in funds that are not so exposed to over-valued countries, most people tend to invest their shares in US and Australian shares – there are many other parts of the world that do not seem nearly as highly valued as US and Australian shares.
If you’d like more information about some of these strategies feel free to give your Sunshine Coast Financial Planner, Mike Beal, a call on 0409 799 279 or [email protected]