Is the stock market now cheap? After the painful declines of the past few months, it may appear so. But appearances can be deceiving.
A more realistic view is that Canadian and U.S. stocks have shaken off their pandemic-era silliness and are no longer trading at wildly inflated prices. They still have a way to go, though, before they become obvious bargains.
A good way to measure their appeal is to look at the cyclically adjusted price-to-earnings, or CAPE, ratio. This gauge of value, developed by Yale economist Robert Shiller, shows how current stock prices compare with the average of their earnings over the past decade. A CAPE ratio of 20, for example, would indicate that stocks are trading for 20 times their average annual inflation-adjusted earnings over the past decade.
The CAPE ratio was nearing historic highs toward the end of last year, when it briefly topped 38, its highest level since the 1990s dot-com mania. Since then it has fallen sharply.
However, CAPE still sees U.S. and Canadian stocks as pricey. U.S. stocks, in particular, still look frothy, with a CAPE ratio around 28, compared with a long-term average of about 16.
One plausible explanation for this lofty reading is that bonds are still paying relatively small yields by historical standards. Since bonds are the main competition for stocks, low payouts on bonds leave investors with little choice but to venture into stocks.
To account for the effect of today’s low bond yields, some investors like to look at what is known as the equity risk premium – a measure of how the estimated returns on stocks compare with the less risky returns on bonds.
The idea here is that equity investors should demand extra return – typically around 5 per cent a year over whatever bonds are yielding – to compensate them for the additional risks that go along with investing in stocks. By this logic, an unusually small equity risk premium would indicate people are overconfident and stocks are therefore overpriced.
The good news is that this is not the case right now. A simple estimate of the equity risk premium indicates that stocks are not unusually expensive when viewed in the context of current bond yields. The not-so-good news is that stocks aren’t outstandingly cheap either.
How you view this situation hinges on what you want from your portfolio.
If you are mainly concerned about generating income for the long run, you can find many blue-chip stocks with tempting dividend yields. Royal Bank of Canada, for instance, now pays shareholders 4.1 per cent, while BCE Inc. pays 5.9 per cent. Both companies are reliably profitable and both are well off their recent highs.
Their only drawback is that both are mature companies with limited room for growth. They may be fine buys for patient income investors, but they could disappoint in the short run, especially if the economy slows.
So what is the alternative? You could wait and see whether a significant slowdown does materialize. With central banks frantically hiking rates to slow down the economy and cool inflation, a downturn is growing more likely by the day. If so, many stocks will get cheaper.
The challenge is that you have to be willing to buy when things look bleakest. This is easier said than done.
It could be especially difficult this time because central banks will not be rushing to investors’ aid. If anything they will be doing the opposite – pushing down on stock prices with higher interest rates as they attempt to put a lid on inflation.
One plausible scenario for the U.S. market comes from Capital Economics. It sees the Federal Reserve hiking its federal funds rate to a peak of 4 per cent by early next year and the S&P 500 sinking to a low around 3,200 by year-end 2023, down about 15 per cent from current levels.
You should not, of course, take any of these numbers as gospel. They’re just educated guesses. The more important point for most investors to note is the relatively long timeline.
By most economists’ reckoning, it will take several months, or longer, for central banks to finish raising interest rates and for inflation to be definitively brought to heel. Stocks don’t typically stage sustainable rallies until policy makers actually start cutting rates.
So take a breath and think over what makes sense for your portfolio. Whether you decide to buy now or wait for a better moment, there is no need to rush. After the frenetic ups and downs of the past two-and-a-half years, this should qualify as welcome relief.
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Ian McGugan