Stock Market Valuation: When to Sell?

The other day I received a well thought out comment and question from one of our readers.  That comment was such that it deserved a post of its own.    The question, “Is there ever a price at which you’d consider selling equities?”  The context of this question was in respect to stock market valuation.  All interesting topics deserving of a post.

Are Stocks the Only Investment Option

Rich from Penny and Rich raised the comment.  You can find it here.  Rich prefaced his question with a challenge:

“We (in the US) are biased toward stock market investing. I understand that the stock market has become the de facto vehicle for investing and retirement accts (and there are good and bad reasons for that), but personally I challenge the assumption altogether. Why do people *need* to invest in stocks?”

Many Investing Roads, Not All of Them Involve Stocks

I’ll start by saying I agree.  There are many roads to success in terms of investing.  Stocks are but one of them, albeit one of the more passive inclusive options.  

Invest in Things You Understand

You should be investing only in things you understand.  It just happens stocks are one of the more easily understood options.    Also, anything you invest in requires some level of diversification.  Stocks are one of the few investments that allow easy diversification.  You can buy pretty much as little or as much of a single stock as you want.   Many investments don’t allow for quite as divisible an investment.  Finally, stocks are passive.  This means no being a landlord or managing a company for example.  That is incredibly powerful for those of us who don’t have time to manage investments.

Reasons to Choose an Investment

But, stocks are not for everyone.  Nor do they need to be the only thing in your investment portfolio.   On this, myself and Rich agree.  I invest in stocks, bonds, CDs, and am looking at real estate.  These are the limits of my knowledge and time.  I know Rich has timber in his portfolio.  I can definitely see value in that investment, I just have no knowledge of timber, so it’s not the right choice for me.  Similarly, I have no time or handyman skills to be a landlord.  So direct rental is out even if I had enough to diversify.    I favor stocks because that’s what fits my situation.

Should Stock Valuation Drive You to Sell?

Which brings us to the big question in Rich’s comment, “is there ever a price at which you’d consider selling equities?”  The easy answer here is certainly.  In fact, I wrote about it in a way a few weeks ago in my post on Tilt.  If things get too frothy in an asset class, I tilt towards an asset class where I have superior long-term expectations.    As noted in that post I do so over longer periods, this means not in the context of an asset price movement during any given week but based on long-term expectations.   This means December’s stock movement has no impact on my strategy, which was already in place months ago.

Defining Overvaluation of Stocks

But here is where things get interesting.   How do we define an asset class as being too frothy?  Or more specifically, how do we value stocks at all?   The valuation touted almost always involves price per amount of earnings.  Sometimes it’s a point in time earnings.  This year my company returned X profit and a share was $Y so the valuation was $Y/X.    It makes sense on most levels to price a stock based on its earnings, this is after all how you would evaluate a business you are purchasing privately.  Stocks are just public companies, so why should it be different?

What Earning to Use in Stock Valuation?

Well, here is the problem.  What Earnings do you use?  Is it today’s earnings?  Is it the companies predicted earnings for next year (forward earnings)?  What about an analyst’s predicted forward earnings?    This gets even more complicated when you start talking about what to include that impacts earnings.  Is a one-off charge for an acquisition or layoff something you should include?    Should you smooth things over a ten year period per the Shiller PE to account for business cycles? 

The Future is Far More Clouded for Public Stocks

Unlike a private business, it’s doubtful you personally have enough information to accurately predict a corporation’s future earnings. Honestly, there are so many moving parts and so much opacity that accuracy is questionable and much shakier than a private purchase.  Applied to the whole market the complications are nearly incalculable.

How Stock Valuation is Done by Analysts

So does the accuracy mean all is lost when deciding to tilt?  No.  It does mean that you have to be very careful.  The best methodology available for individual stock analysis is really comparing like companies or time periods for all available metrics, of which valuation is one. Ie. if I want to know if Hilton is a good company to invest in I have two choices.  The first is to compare Hilton in prior periods to itself today. 

The second is to compare direct competitor to Hilton like Marriott.  The problem is even while these things may seem similar on the surface, differences in operations may cloud your conclusions. For example, even in the same industry, there can be marked differences between these companies business models that make the comparison apples to oranges.  For example, say one of them franchises versus the other owns all their real estate.  That would lead to significantly different risk and leverage.  Different risk means different expectations in valuation and future earnings.

Expanding Stock Valuation from Individual to Market

If we expand this out from an individual stock to a market index then you are really left with comparing to other asset classes, indexes, or time periods.  All of these have the same risks I mentioned above.  The other asset class could have different risks, for example, inflation.  The other index could be influenced more by a specific industry (the overweighted impact of tech on the S&P 500 comes to mind).  Or the time period could be characterized by different macro and micro economic risks (Say the four horsemen of the apocalypse, technology, or shifting societal tastes).

Stock Market Valuation Accuracy is Questionable

Which comes down to the fundamental truth.  Our accuracy in claiming the stock market is overpriced is questionable except for in the rearview mirror.    Take 1996.  I’m fond to point out that Allan Greenspan and Robert Shiller both brought forward the ideas of Irrational Exuberance in 1996.  Ultimately a bubble was created around internet stocks that burst in 2000.  Still, the stock market has never dipped down to the level of 1996, even during the depths of that 2000-2002 crash.  This implies at least that 1996 was not the time to sell based on valuation but only thereafter.  For the record, our price per earning by any of the commonly held measures is hovering near 1996 levels.

Stock Overvaluation is Not a Sure Thing  

This indicates to me that we cannot be sure that today stocks are overpriced.  Is there a point where we could?  Probably.  But at current levels, as the Magic 8 Ball says, “Cloudy, try again”.  Now, this does not preclude me tilting my investments in response to the possibility stocks are overpriced.  In fact, I’ve admitted to doing this to some degree.  I’ve moved my allocations more towards small caps and internationals based on my belief that these are undervalued opportunities in relation to their large-cap peers. 

I am contemplating tilts towards real estate as I’m starting to see opportunities there in certain regions of the country.    It does mean however that wholesale abandoning of your existing investment categories based on current perceptions of pricing is a bad move.   In essence, you can be confident enough that stocks are overpriced to tilt your portfolio, but not be 100% sure enough to abandon them.  I do not believe Rich was pushing the idea of abandoning stocks altogether, yet this is an important footnote.

Up Next: Dry Powder

Which really brings us to the final piece of my discussion with Rich.  The concept of maintaining dry powder for when the market goes south.   I plan to address this concept more in our post on Wednesday to keep this in manageable bites.   Sneak preview, I’m not a fan of dry powder. Stay tuned.

How do you valuate stocks?

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