The current CAPE ratio for the S&P 500 is the third highest valuation on record, beaten only by the extremes of 1929 and 2000. US-based investors appear to be standing at the precipice, potentially peering into the abyss. Yet at the same time, UK markets look far cheerier, with a CAPE ratio of 15.4 only marginally above the long term average. All is good for us Brits, isn’t it?
When the US Sneezes…
Well, possibly not if you look at the chart above. During the 1929 and 2000 stock-market peak-to-trough drops, UK markets still suffered a fall of approximately 48% and 34% respectively. Admittedly the CAPE ratio of the FTSE 100 peaked at around 27 at the turn of the millennium, which is far less favourable than the current environment. Perhaps we have less to fear due to our more reasonable valuation. However for me, now is the time to be cautious. And who better to listen to in times like these than investing legend Howard Marks.
Earlier in the week I re-read Marks’ latest memo, entitled ‘There They Go Again…Again‘. If you haven’t already read it, I highly recommend it. (Bitcoin advocates may find this memo distressing). One part in particular jumped out at me:
Asset prices are high across the board. Almost nothing can be bought below its intrinsic value, and there are few bargains. In general the best we can do is look for things that are less over-priced than others.
Being someone who is interested in attempting to determine intrinsic value for equities that I purchase, I was drawn to this comment. You may feel otherwise but for me, if I can’t make a good guess at a range of possible valuations for a stock, I can’t buy the stock. It just doesn’t sit right with me. And yet in a bullish environment such as ours currently, maintaining the discipline to stick to this methodology is truly put to the test. When you’re sat watching your peers make small fortunes on high-momentum stocks, it can become easy to end up tagging along for the ride. It is the story of every major bubble in history, and it never ends well. Just ask Sir Isaac Newton. Valuation goes out the window when investor sentiment becomes overly optimistic, and equities (or anything, really) are graced by ‘the big Mo’.
Which is why I think it is important, particularly in the current environment, to maintain the discipline to not lose sight of valuation when assessing the merits of a prospective investment. During market highs, investors care less about investing in attractively valued companies, and more about buying into whatever is ‘going up’. That’s not to say momentum shouldn’t play a part in an investment strategy, but it shouldn’t be sole reason for buying. The more this outlook becomes embedded in an investors psyche, the larger the sense of detachment he or she has from the fundamentals of a company. There danger lies.
Buying at higher valuations lowers prospective returns. Take a look at the FTSE 100 as an example. After hitting a peak of 6,930 on December 30th, 1999, it took until March of 2015 to get back to that same level. Over 15 years. We can look back and see that the CAPE ratio, as mentioned earlier, hit approximately 27 during those heady days. One of the highest, if not the highest, it has ever been. The financial crisis came and went without ever hitting that peak.
Looking for the Less Over-Priced
So the current UK valuation is somewhat favourable, and in fact only a few points higher than the low of around CAPE 11 reached during the depth of the financial crisis. This would suggest we have some runway ahead of us. But then there’s that dang S&P 500 and it’s lofty valuation. We’d be foolish to think we’d not be affected by a draw-down in US equities. I’m not sure of the best way to prepare for such an outcome, but personally I’m looking to balance this against the suggested upside presented by current valuations in the UK. If there’s headroom to yet grow further, I want to ensure I’m able to participate. I have therefore positioned my portfolio so that it sits on a forward P/E of only 15.8 times earnings. Finding equities on cheap valuations is becoming more and more difficult, so I’ve settled for simply trying to identify stocks that are less over-priced than others. Beyond that, I defer again to Howard Marks:
“Move forward, but with caution.”
I want to hear your thoughts. Leave a comment, or find me on Twitter @BritishInvestor.