There Is No Simple Rule Of Thumb For Stock Market Valuations

In finance, there are often well-known rules of thumb for investing that can easily become embedded in consensus thinking. For market timing, the well-worn “Buffet ratio” compares the value of stocks relative to the nation’s economic output. Other market timing formulas compare the relative value of government bond rates to the dividend yield provided by stocks. But are these generic sound bites telling the whole story in value investing?

Market Valuation Rules

“This time it’s different” is a mantra often used to justify historically high stock valuations. Near the turn of the century, the Internet boom was heralding a new dichotomy that would disrupt society as never before – and thus assigning a multi-million valuation to a company, pets.com, whose primary asset was a sock puppet, could be justified.

Q3 hedge fund letters, conference, scoops etc

In reality, the projections of massive societal change coming from a technical revolution were proven more than hyperbole. Technology has revolutionized society to levels that, in many cases, have exceeded the early hyperbole. But many of the companies without strong product offerings, such as pets.com, fell by the wayside. Others, such as Amazon.com and Google, who built a behemoth from the early search engine Alta Vista, have endured and rewarded patient investors and proven wrong those who said at the time stocks were overvalued.

This all leaves a question: Can general “rules of thumb” be accurate regarding stock market valuations?

The “Insecurity Analysis” blog points out that as it relates to today’s market valuations, he doesn’t know if the market is set to fall. Rather, it is important for investors to understand that indicators pointing to an over-valued stock market generally have flaws.

The most popular of the stock market valuation indicators, the Buffet ratio, started by simply comparing the value of the stock market to Gross National Product (GNP). While recognizing limitations, Buffet said “it is probably the best single measure of where valuations stand at any given moment. If the ratio approaches 200%–as it did in 1999 and a part of 2000–you are playing with fire.”

The ratio was later altered to substitute Gross Domestic Product (GDP) but the problems persist.

“One obvious issue with this ratio is that it compares companies with increasing international exposure to domestic economic activity,” the blog post titled “Beware of Market Timing Rules of Thumb.” “Another potential issue revolves around higher corporate profit margins. While profit margins fluctuate with the economic cycle, changes in industry composition and industry concentration could be elevating margins long-term.”

Market valuation rules of thumb are also subject to underlying societal trends that can fundamentally change the equation.

Simple Rule Of Thumb For Stock Market Valuations

Starting in the late 1990’s a shift in trade policy significantly benefited multi-national corporations and corporate profits as a share of GDP began to rise meaningfully. At the same time, the information technology and financial sectors of the economy began their rapid growth. These were core shifts taking place that meaningfully impacted stock valuations – and provided an upward tilt to stock valuations in these sectors.

There are other factors that can influence the underlying valuation of stocks. When market concentration occurs, and the largest players become an ever larger share of the market pie and enjoy higher pricing power. Here, too, stock valuations can rise to new multiple highs.

“Over 75% of U.S. industries have registered an increase in concentration levels over the last two decades,” the report highlighted. “Firms in industries with the largest increases in product market concentration have realized higher profit margins, positive abnormal stock returns, and more profitable M&A deals, which suggest that market power is becoming an important source of value.”

When a market has its fundamental underpinnings change and the core rule of thumb does not change but it is nonetheless impacted by fundamental market changes, something could be amiss with the rule of thumb itself. It can become too simple to speak to the complex nuance of today’s world.

This article originally appeared on ValueWalk Premium

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