Last October I wrote an article about tuning out the news as investors – Falling Crime Rates and Other Reasons to Tune Out the News. In it I wrote about the gap between public opinion being that crime rates are up when, in fact, crime rates are down, continuing a trend dating back to the 1980s. The trend lines aren’t perfectly straight, but the downward trajectory is absolutely clear and continuing. Part of the disconnect is due to the news media, which long ago learned that featuring crime helps sell newspapers – and advertisers. When we hear and see reports on crime regularly, or if we are victims of crime ourselves, human biases cause us to give disproportionate weight to crime.
(And by the way, there are other commercial interests at play. Home alarms and guns are just two industries that benefit from your feeling that crime is increasing rather than decreasing.)
The next day I received a note from a reader telling me to get my head out of a certain part of my anatomy that, from a purely physiological perspective, it could never actually reach. The writer said he had his car broken into twice and crime seemed to be everywhere.
He also seemed to be completely unaware that his note was evidence of exactly my point. He was using a few personal data points to reach a conclusion that not only wasn’t supported by the data but was directly contrary to the data.
I bring this up to note that humans are great storytellers. And often the stories that are the most influential are the personal ones. The myths we tell ourselves. Whether they’re true or not. Whether they’re based on facts or not.
With that said, let me get onto today’s subject: why the stock market is NOT overvalued.
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One of the things that gets written about in the financial press from time to time is that the market is overvalued. The assessment of being overvalued is part art and part science.
In a speech on December 5, 1996, legendary Fed Chairman Alan Greenspan famously wondered if “irrational exuberance” was pushing stock prices to untenable levels. And the phrase irrational exuberance was launched into the investing lexicon.
The opposite of irrational exuberance would be irrational fear – when all (or most) economic indicators are bullish but the market remains bearish. And that’s exactly what I think we’ve all been seeing in the market since October 2022 – irrational fear. The stock market, led by the Magnificent 7 (or 4 or whatever it is), has done well.
Inflation moderated then stalled, and the market is likely to be aided by a Fed rate cut of 25 basis points in September. Jobs have remained strong, with the July numbers coming in somewhat softer than expected. Corporate profits are strong; wages are growing moderately. Overall, that’s a pretty good picture that would normally have people feeling more bullish than they are.
Many pundits and investors talk about the high PE (price/earnings) multiples as proof that the market is overvalued. I don’t, and here’s why.
Below is a chart of PE multiples for the S&P 500 over nearly the last century. As the orange line indicates, with one or two notable exceptions, smoothing out the ups and downs, the overall picture has remained fairly steady, with a gradual upward trajectory. (I will concede that during a brief period in 2010 when the average PE shot up over 120, the market was overvalued.)
That long, slow PE growth is enabled primarily by two things – growing productivity and greater demand for stocks.
I have written previously about growing productivity. I won’t repeat that all here except to say that purchasing stock in a company today whose productivity will continue to increase in the future enables you to pay a higher PE multiple and still make money over time.
The second, and more immediate factor that influences PE ratios is the market, specifically the demand for stock. That’s pretty straightforward. Demand for a stock increases and the price rises, increasing the PE ratio.
Of course, there is no “should” when it comes to talking about the stock market. The market is always right and that is as true now as ever. Given the strong economic indicators, however, consumer sentiment about investing would typically be greater than it is.
What’s the evidence that stock market sentiment is low? The record amount of dollars currently invested in money-market funds. More than $6 trillion!
Board of Governors of the Federal Reserve System (US), Money Market Funds; Total Financial Assets, Level [MMMFFAQ027S], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/MMMFFAQ027S, August 21, 2024.
Looking at this Federal Reserve chart, you can see money market funds were first created in 1980. Their popularity slowly grew over the next two decades, peaking just before the dot-com crash of 2001 and then pulling back in 2009 after the financial meltdown. That seems to mark the end of the adoption phase of money market funds.
Since the market from 2010 through 2021 was so strong, and relatively steady – and money-market rates were low – it is safe to say that our economy seems to currently have a baseline money-market level of approximately $3 trillion. Regardless of their being opportunities for better returns elsewhere, we seem to want to keep about that level of money available in money market funds because it’s easily accessible and highly liquid and it’s easy. Like many people, most of my assets are in stocks but at any given time I also always have some money – proceeds from a sale, dividends, interest, etc. – accumulating in a money-market account, waiting to be redeployed. Looking at the chart above, it appears collectively those money market funds come to about $3 trillion.
The pandemic caused the Fed to increase Rates to control inflation, which caused uncertainty, which combined to bring in another $3 trillion – out of what I would call an excess of concern. (One might even use the term irrational fear.)
As the Fed continues on its stated path to bring down rates over the next couple of years, money-market funds are going to look less and less attractive and it is reasonable to assume a significant amount of that $3 trillion of excess funds will ultimately find their way back into the stock market, which has a long and proven history of profitable growth, high liquidity, and easy accessibility. For the sake of argument, I’m going to say $2 trillion ends up back in the stock market.
While some of the doomsayers will talk about how overvalued stocks are and recommend other moves, I say compared to what? Gold? Crypto? Commercial real estate? NFTs? When I hear people say stocks are overvalued, I always ask, “Compared to what?”
Now, I’m not saying stocks can’t get overvalued. We get investing fads that can drive stocks beyond a sustainable PE multiple. Nvidia comes to mind. GameStop too.
Overall, as the first chart above shows, PE multiples are at a historically supported level, and there are a couple of prominent factors positioned to continue to push those values higher in the coming years.
There are a number of estimates of the total market capitalization for U.S. stock markets that fall in the $45-50 trillion range. As $2 trillion comes back into the stock market, that represents a 4%+ increase in demand. And that’s going to push PE ratios higher.
And, we will be comfortable paying those higher multiples because we know the productivity growth from AI is just getting started and is likely to continue to drive value growth for the next 20 years at least. As an investor, there is nowhere I’d rather be than in the stock market.
Throughout it all, I and the rest of the team at Cabot Wealth Network will be here, researching and publishing our best research, insights and recommendations to help you achieve your best investing results.
Yours for successful investing,
Ed Coburn
President & Publisher
Cabot Wealth Network
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