The stock market is off to its worst start in history this year. Not only that, the losses over the past few weeks have come amid one of the most rapid declines over the past few decades. This has some coming to the conclusion this has to be buying opportunity.
I’ve seen plenty of headlines and articles lately featuring advisors suggesting investors ‘stay the course’ or even ‘buy into the depressed prices.’ But is this really good advice for the average investor?
There are a couple of questions to be answered here. First, how ‘depressed’ are prices? Are stocks actually cheap? I think most investors would be shocked to find out that, not only are stocks not yet cheap, they are, in fact, still very expensive.
Using Warren Buffett’s measure of total market cap-to-GDP, stocks are still well above their long-term average valuation even after the declines we have seen recently. In fact, the only time they were more expensive than today, even after the recent selloff, was during the height of the dotcom bubble in 1999-2000.
Furthermore, “well above fair value,” carries a couple of unpleasant implications. First, it means returns going forward are going to be well below average. “The price you pay determines your rate of return.” Pay a high price and you are guaranteed a low rate of return.
The chart below shows the expected rate of return from current valuations compared to the yield on the 10-year treasury note. Right now investors are taking much greater risk for less return than can be gained from the “risk-free” rate. This makes it hard to justify stocks as an, “investment,” currently.
Second, paying well above average valuations means you expose yourself to above average risks. If stocks fell back to their long-term average valuation based on this measure, it would mean about a 40% decline from current levels. For valuations to actually become ‘depressed,’ it would take an even greater decline. And the history of valuations and drawdowns validates this risk.
The higher the valuation you pay for stocks, the larger the drawdown likely to be.
via GMO pic.twitter.com/ciYYrH69jT
— Meb Faber (@MebFaber) January 20, 2016
So simply based upon valuations it’s not a great time to buy stocks. However, Warren Buffett has also famously advised investors to, ‘be greedy when others are fearful.’ Have investors become unduly fearful which would mean it’s time to get greedy?
In the short-term, one could argue we are seeing a certain amount of fear in the markets. CNN’s fear and greed model recently got pretty low. DSI, another sentiment indicator, also shows investors have become pretty bearish recently.
Chart via Nautilus
It’s very important to note, however, that these are very short-term indicators. For this reason, they are probably only appropriate for short-term traders. On a long-term time horizon, we are only just now coming off of one of the extended periods of bullish euphoria in history for the stock market. Is a bit of short-term fear enough to form a long-term bottom?Chart via Yardeni
One way to look at longer-term investor sentiment is to observe the total amount of leveraged speculation in the markets relative to the overall economy (as measured by margin debt-to-GDP). When leveraged speculation is very high, investors can reliably be considered greedy and vice versa.
Currently, the amount of leveraged speculation relative to the economy is about as high as it was just prior to the dotcom bust and the financial crisis. In other words, very rarely have investors ever been more greedy than they are today, which should remind you of the other half of Buffett’s advice: ‘be fearful when others are greedy.’
All in all, it’s difficult to make the case it’s time to buy stocks today for anyone other than a very short-term trader. They remain very highly valued and investors have not become fearful yet on a long-term time frame by any stretch of the imagination.
These are two of the reasons I have been recommending investors consider reducing risk in their portfolios over the past year or so. If you’re a long-term investor, it’s still not a great time to buy. Considering the poor returns and elevated risks stocks pose currently, you may want to do just the opposite in order to match your risk tolerance and time frame to this reality.