“I think the stock market is overvalued now,” is a common refrain that I’m hearing from most of the individual investors I have recently been coming in contact with. Consequently, many of these same investors are also currently eschewing investing in common stocks because of that fear. Although I do not agree that the market is currently overvalued, I believe I understand why so many people think it is. Individual investors currently believe the stock market is overvalued because of two common fallacies that at first blush appear to be logical.
This is the first, of what will be a sequence of 10 subsequent articles designed to show how retirees, or pre-retirees, can construct dividend growth portfolios comprised of high quality blue-chip stocks all purchased at fair value, in spite of what many believe to be an overvalued market. I do not believe that investors should be denied the opportunity to create sound and prudent portfolios capable of producing long-term capital appreciation and a growing dividend income stream at reasonable levels of risk because of unsubstantiated fears based on the fallacy that all stocks are overvalued.
Simply stated, I will clearly illustrate that they are not. Some are, but many are not. Moreover, I further intend to demonstrate that there are a more than adequate number of undervalued stocks with which investors can build conservative high quality and properly diversified dividend growth portfolios in today’s environment.
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The First Fallacy: Stocks Are At All-Time Highs And Therefore Overvalued
The first fallacy is based on what appears to be the logical conclusion that since many stocks are trading at all-time highs that they must simultaneously be overvalued. In truth, a stock can be trading at an all-time high, and still be reasonably priced or even undervalued. Below I offer two clear examples, one that is undervalued and one that is fairly valued, to illustrate my point. For the sake of balance, I will also add a third example of a stock that actually is overvalued. As I will elaborate on later, is a market of stocks not a stock market.
International Business Machines Corp. (NYSE:IBM) Is Undervalued But Price Is At An All-Time High
I offer the following 21-year earnings and price correlated F.A.S.T. Graphs™ on IBM as a case in point of an undervalued stock trading at an all-time high. Clearly, IBM’s stock price is the highest that it’s ever been, even though its current P/E ratio of 13 is below its historical normal P/E ratio of 16.8. Therefore, even though IBM is trading at an all-time high price, its current valuation is historically low because earnings (the orange line) have actually grown faster than the stock price.
The following graph plotting IBM’s historical year-end P/E ratio is another way to see this clearly. A quick glance shows that the historical fiscal year-end P/E ratios on IBM (the black squares on the dark blue line) show that IBM’s P/E ratio has actually been falling since 1999, and is currently on the low end of normal. To repeat, IBM reflects a situation where earnings growth has been much stronger than price appreciation, and therefore, the shares remain undervalued even though share price is at an all-time high.
The above graphs illustrate that IBM is undervalued based on historical earnings growth rates. The following estimated earnings and return calculator graph shows that it is also moderately undervalued based on current consensus forecasts.
Stanley Black & Decker, Inc. (NYSE:SWK) Is Fairly Valued But Price Is At An All-Time High
The following 21-year earnings and price correlated F.A.S.T. Graphs™ on Stanley Black & Decker (SWK) clearly illustrate that the company is currently fairly valued. The black monthly closing stock price (the black line) is sitting right on the orange earnings justified valuation line indicating fair value. Consequently, in this example, we not only see that price clearly tracks earnings over the long run, we also see several examples when the stock was overvalued (the price is above the orange line) and when the stock was undervalued (the price was below the orange line). But more importantly, we see that price always returns to fair value, whether it is over or under. Nevertheless, Stanley Black & Decker is trading within its all-time highs, but yet the company remains fairly priced with a P/E ratio of 15.5.
A review of the historical fiscal year-end P/E ratios of Stanley Black & Decker show that its current P/E ratio is clearly within its normal range of valuation. In other words, although the stock price is near an all-time high, current valuation is well within its earnings justified levels, and even arguably slightly on the low side of normal value.
The consensus 5-year earnings forecast for Stanley Black & Decker expect earnings growth to accelerate to 12% per annum. This rate of growth justifies a 15 to 16 P/E ratio, which is precisely where the company is currently valued at today by the market place.
Lowe’s Companies, Inc. (NYSE:LOW) Is Both Overvalued And At An All-Time High
There are several lessons that the Lowes’ graph teaches us. However, the most important one is that the company is clearly currently overvalued as its price is significantly above the orange earnings justified valuation line. A second important lesson is that in the long run price (the black line) tracks earnings. In other words, where earnings go stock price soon follows. The third important lesson is that we see a legacy of the company’s price rising above the orange earnings justified valuation line, only to see it soon return to fair value. A similar pattern occurs when the price falls below the orange earnings justified valuation line.
Interestingly, Lowes Cos. Inc. is expected to continue growing future earnings at a rate that is very consistent with its historical growth. However, even considering that the consensus of analysts expects earnings growth of 16.4%, Lowes is clearly overvalued at today’s 22.1 P/E ratio. Perhaps even more interesting, because of this high-growth expectation, Lowes could still actually be a very good long-term investment even at these high valuation levels. The 5-year estimated total annual return, including dividends, is expected to be 13.6%.
On the other hand, based on the historical patterns discussed above, prudence might suggest that over the shorter term you might be given an opportunity to buy this company at a better valuation, which could actually reduce long-term risk while simultaneously enhancing your long-term rate of return. My point being that overvaluation does not necessarily indicate a bad investment or future losses. Instead, as in the case of Lowes, it might simply be indicating that you are taking higher risk than you might need to in order to achieve an acceptable future return.
The Second Fallacy: After a 3½ Year Run Stocks Must Be Overpriced
The second fallacy is based on the misconception that since the market had a very strong run, not only this year, but over the past 3½ years, many people automatically assume that it must be overpriced. However, the truth is that the market, just like the IBM and Stanley Black & Decker examples above, has had a rise that closely correlated to its earnings growth coming out of the great recession of 2008. In other words, the market may be at an all-time high, but not necessarily overvalued.
The overall stock market as represented by the S&P 500 is well within its 200-year historical normal P/E ratio average of between 14 to 16 times earnings. The following earnings and price correlated F.A.S.T. Graphs™ on the S&P 500 illustrate that its price is well within its historical earnings justified valuation. If the overall market is high, it’s only by a smidgen, and certainly not beyond reason or fair value norms.
The Greatest Investor Fallacy Of All
What has been written thus far leads me to a discussion on what I believe to be the greatest investor fallacy of all. This is the fallacy of making investment decisions based on predictions about the general state of the stock market. In other words, I do not believe in predicting markets, instead, I believe in analyzing individual companies based on their own merit and then building my portfolios one company at a time.
Moreover, my years of experience and research have led me to conclude that whether the market is a bear or bull, there will always be fairly priced, overpriced and underpriced individual companies to be found. Therefore, I believe that investors are better served by looking for good businesses at sound valuations, regardless of what they believe the market may currently look like. In the long run, the evidence clearly supports the idea that it is time in the market,