Short read: Stocks Are More Expensive Than They Used to Be. Because the Companies are So Much Better

The sustained rally in the American stock market has surprised many, raising calls of a bubble scenario or irrational exuberance. The naysayers use data points such as how whilst the American economy contributes 30% to world GDP yet its stockmarket makes up 75% of the global market capitalisation. This misses the point that some of the largest American companies are no longer just a play on the American economy – the likes of Nvidia, Microsoft, Apple, Google, Amazon, etc dominate the world in their respective sectors. But a more pertinent point is that valuations measured by Cyclically Adjusted Price to Earnings (CAPE) ratio (a measure that’s considered to have decent predictive power) is at an all-time high resembling the dotcom boom scenario. In this blog, Michael Batnick highlights why past CAPE ratios may not be relevant today.

“To use a long-term average that goes back to the late 1800s is foolish for threereasons. First, we didn’t have CAPE data back in 1929. It was first “discovered” in the late 90s. The discovery of data in financial markets changes the very essence of it. Markets are not governed by the laws of physics. They’re alive. They adapt and evolve and adjust, like an micro organism.

Second, the CAPE ratio has been rising over time since the 1980s. We’ve only visited the long-term average once in the last 25 years, and that was at the bottom of the GFC. If that’s what it takes to return to the long-term average, maybe you should reconsider what an appropriate comp level really is.”

Yet the most important point he makes in his defence is that companies are way better today than in history and hence justify a higher CAPE. He highlights that Free Cash Flow margins for companies are highest today (infact have been continuously rising through history in line with the continuously rising CAPE)

“Finally, here’s another one that shows how different today’s market is from the 1980s, when CAPE was in the single digits. About 60% of the S&P 500 was in manufacturing back then. Today its ~15%. Technology companies, with higher margins and larger moats, have taken their place. These are not the same businesses, and investors are rightly treating them that way.”

We recommend reading the blog for its interesting charts which drive home the point.

Despite that, Batnick ends with a word of caution to moderate our expectations of returns going forward. Indeed, the Marcellus’ Global Equities team is underweight Big Tech and instead sees more attractive opportunities in mid-caps and industrials.