What Valuation Can Tell You About the Market – And What it Can’t

Episode Summary

Executive Summary: The episode examines how to measure market valuation, emphasizing that different metrics and calculation methods can materially change the result. The hosts argue valuation is poor for short-term timing, but useful for estimating long-term expected returns and framing relative value, especially within a market that is broadly expensive and where value stocks remain cheaper than growth on a relative basis.

Main Topics: Ways to measure market valuation (Priority: 5/5): Discussion of common valuation metrics such as P/E, price-to-book, price-to-cash-flow, the Buffett indicator, and O'Shaughnessy's price-to-integrated-equity approach. Why calculation method matters (Priority: 5/5): Explains that a median stock-level valuation is useful for equal-weighted portfolios, while market-wide valuation should be market-cap weighted and use a harmonic mean for P/E. Valuation as a poor short-term timing tool (Priority: 5/5): Argues that valuation provides little to no insight into one-to-three-year market performance and cannot reliably forecast near-term drawdowns. Valuation and long-term expected returns (Priority: 4/5): Shows that expensive markets can imply lower decade-ahead returns, but those outcomes often arrive through large rallies followed by severe bear markets. Current market expensiveness (Priority: 5/5): Reviews percentile rankings across multiple metrics showing the market is very expensive versus its own history, with especially elevated price-to-sales and price-to-cash-flow readings. Relative value in value stocks (Priority: 4/5): Compares value vs. growth and concludes value remains relatively cheap even after a strong rebound, though less cheap than at the market bottom.

Key Arguments: Market valuation can be measured in multiple ways, and the choice of metric matters because it changes what is being captured. A median stock-level valuation is appropriate for equal-weighted investing, but not for assessing the S&P 500 or the market as a whole. A proper market P/E must be calculated using a harmonic mean of earnings yields, not a simple average of P/Es, to avoid outlier distortion. Valuation is ineffective as a short-term market-timing tool; expensive markets can remain expensive for years and still produce strong returns. Valuation is more useful for long-term return expectations and planning, such as retirement or withdrawal-rate assumptions. Mean reversion should not be based on static historical averages because market norms can shift over time. The current market is broadly expensive across most valuation measures, and the average stock has become expensive too, not just the mega-caps. Value stocks are still relatively cheap versus growth, which may support a relative-value thesis, though absolute valuations have risen materially since the bottom.

Data Points: Market P/E percentile: 96th percentile - Current median-stock valuation using P/E within the podcast's market valuation tool. Market CAPE percentile: 92nd percentile - Current median-stock valuation using CAPE within the tool. Current-year earnings valuation percentile: 90th percentile - Current median-stock valuation based on current-year earnings estimates. Price-to-sales percentile: 99th percentile - Current median-stock valuation; noted as especially high because profits have been above average. Price-to-cash-flow percentile: 98th percentile - Current median-stock valuation based on cash flow. Historical CAPE in 1997: 30 - The market crossed this level in 1997, which was then the highest CAPE ever observed. CAPE at 2000 peak: 45 - CAPE continued rising after 1997 before the bubble peaked in 2000. Annualized returns from 1997 to 2000: 20%+ per year - Demonstrates why high valuation did not prevent strong near-term gains before the crash. Value P/E percentile: 50th percentile - Absolute valuation of value stocks after the post-crisis rally. Value price-to-cash-flow percentile: 90th percentile - Absolute valuation of value stocks versus its own history after the rally. Relative value P/E percentile: 4th percentile - Value versus growth comparison using the cheapest 20% of stocks vs. the most expensive 20%. Relative value CAPE percentile: 8th percentile - Value versus growth relative valuation. Relative value price-to-sales percentile: 8th percentile - Value versus growth relative valuation. Relative value price-to-cash-flow percentile: 7th percentile - Value versus growth relative valuation. Tool history: Since 2005 - The Validia market valuation tool's available historical window. Historical average CAPE: 17-18 - Referenced as the long-term market average, though the speakers caution that this average may have shifted higher over time.

Pivotal Quotes: "the value to investors of all this stuff is very, very little. But what value it definitely is not is predicting anything over the short term." — Jack: Summarizing the limited usefulness of valuation for market timing. "valuation of the market tells you effectively nothing about what's going to happen in the next one to three years." — Jack: Explaining why high valuation should not be used as a short-term crash signal. "the average, you know, you can always say, all right, the market average valuation over the long term, 80 years is X, Y or Z. But it's important to understand that changes." — Jack: Discussing why long-term historical averages may not be fixed anchors.

Implications: Investors should use valuation mainly for long-horizon expectations and relative positioning, not near-term market calls. The current setup suggests broad market expensiveness, but value may still offer relative opportunity versus growth.