Rampant overvaluation - selling beginningThe lofty stock markets are starting to wobble, with selloffs’ frequency and sharpness increasing. The dominant reason the Fed’s stock levitation is running out of steam is severe overvaluation. Stocks are just far too expensive today compared to historic precedent, a dangerous state seen when bull markets are topping. Rampant overvaluation is a glaring warning sign to investors that selling is just beginning.
Investing is all about buying low then selling high. So the price paid for any particular stock is the most-important and often dominating factor in its ultimate price-appreciation success. The surest way to grow rich in the stock markets is to buy good companies at low prices, the prudent contrarian approach. Even buying great companies at high prices leaves little room for those stocks to run higher, so they rarely do.
Low and high stock prices are not defined by absolute share levels, which are irrelevant. A $10 stock can be expensive while a $100 stock is cheap. The key is valuations, or where any stock price is trading relative to its underlying company’s earnings stream. The lower any company’s stock price compared to its profits, the cheaper it is. The more earnings investors can buy per dollar of share price, the better.
This concept is so simple, yet most investors foolishly choose to ignore the valuation price they are paying. Imagine buying a house as a rental property, with expected annual rental income of $30k. If you can get that house for $210k, 7x earnings, it will pay for itself in 7 years. That’s a great deal! But if that same house is priced at $630k, 21x, it’s a terrible deal. It will take far too long to earn back your investment.
Price paid is everything, yet stock investors don’t hesitate to pay 21x earnings and higher for stocks! While not only irrational, a century and a quarter of US stock-market history shows this rarely works out well for investors. And the flagship US broad-stock-market index, the S&P 500, is now priced well above that 21x historical expensive level. Such valuations usually signal a major bull-market topping underway
A.Hamilton