Is the Stock Market Overvalued in 2025?

Is the market overvalued? That is the topic today on "The Informed Investor". Thanks to everybody for joining, I'm Mark Gochnour, joined today by Jake DeKinder and Dr. Wes Crill. As I think about it, we've never established your PhD. What is your PhD in? It's in material science and engineering. You're just a lowly CFA. I'm sorry, I'm trying to keep up. I'm trying to keep up. I was thinking about that. You and I started almost in the exact same month or so, didn't we? I just hit my 15-year anniversary last week. Yeah, mine will be in three weeks. Yeah. Yeah, well, makes us veterans. I don't know the point of that, but I got a few years on us. Mark's got a few years. I got a lot of years Mark's got a few years. on you guys, absolutely. And I'm the token CPA for the group. You got your CFA too. I go a CFA. You're a smart cookie man. We got all the bases covered between the three of us. Right? My role here, I'm the eye candy. I mean let's be clear. All right, how about some headlines? Let's do it. All right, we love headlines. We're gonna start with a couple here. The first one, lofty US Stock Market valuations bank on earning strength. And then another one. Five signs of a market bubble investors are tracking. Now I do wanna highlight before we get into that a little bit, we do have a special guest on this show today. Well, you're our special guest. We have a special, special guest. We got the magic eight ball today. Do you steal that off my desk? I did steal it off your desk. And here's the question, magic eight ball. Is the stock market overvalued? So let's just see here what it's saying. Whoa, it says yes. It literal says yes. Cut the program. Okay, so that was the shortest episode we'll ever have. All right, let's talk about it, we got one opinion. Is the market overvalued? Magic eight ball said yes. Let's get your thoughts on this one around that. How do we think about the price of a security and what goes into that? Determine if it's overvalued. Let's start with you, Jake. Well, I mean, how do you think about the price of anything? I mean, let's say you wanted to go, you wanna go buy a restaurant, right? So how would you value a restaurant? How would you come up with a price for a restaurant? You'd say, well there's all of the booths and chairs that are in there. If I own the building, that's great. The equipment that's in the back, you know, maybe they've got a wine collection. I'm gonna value all the stuff that's there, right? And then you say, but also we're gonna generate cash flows going out into the future over the next one, three, five, 10 really indefinite future. But to come up with a price today, you'd have to bring those future cash flows back to today's dollars, right? And that's discounting them back. But really, I mean that's the price that how you would come up with the price of a restaurant if you wanted to pay for it. And when people are thinking about companies, that's what they're doing. What's the company got, and what's the money they're gonna make out in the future discounted back to today? Sorry, one thing I'm just gonna highlight is you talk about the discount rate. So you buy all this stuff and you discount those flows at a certain rate. That rate is your return as an investor. So I just wanted to connect Yeah, yeah. You can think about those two together, you're right, yeah. Yeah, so just when we're talking about a discount rate, that's the return has Expected return. an investor has on that investment. All right, sorry, Wes. No, I mean you guys nicely summarized valuation theory, I think of the prices, what you expect to receive in the future discounted back to the present. And that has ramifications, especially if you think about what a high versus a low price would imply. And I think this is where you get to merging with some of the headlines about what people are interpreting from today's prices. A price can be high for one of two reasons. It can be the expectations for the future. So the expected future cash flows are high, or it could be the case that those future cash flows are discounted at a lower rate. And the challenge once we start talking about with stocks is it's very difficult to disentangle which one of those is currently at play. Explain why a discount rate would be higher or lower. The discount rate reflects a number of things, right? So it could be the riskiness of the investment. So all that's being equal investors prefer lower risks. So a higher risk investment, they're gonna demand a higher rate of return. It also can take into account other effects like taste and preferences. You know, valuation theory is totally consistent with that. So this is gonna lead to investors demanding higher or lower rates of returns for different securities. On the cashflow side, you're talking about built into those cashflow, the market's pricing in some sort of a estimated growth rate too. On those, how do you know which is which? Can you come up with what an estimate is? Well, you really can with stocks. I think that's the challenge is, you know, say valuations go up like they've been rising for the US market in recent years. So that could mean one of two things. One, it could mean the expected returns are now lower than they were before. If it was a discount rate effect, it also could mean expected future cash flows are now higher than they were before. Both of those are consistent with rising valuations. And if you can't tell me which one is which, then you really can't make a solid prediction about how expected returns have changed. And you know, we should draw a distinction between this in bonds for example. So because you've taken the uncertainty off the table when it comes to expected future cash flows with bonds, you know, when your coupon payments are scheduled, you know when the principal repayment is gonna take place. So with bonds, when the discount rate goes up or when your yield goes up, prices go down. So you can see that connection more one-to-one. But with stocks it's just not as clear cut of an interpretation. Is that a challenge with stocks in general? That they're just noisier? It is. When we say noisier, sorry, what do we mean by noisier? So what it means is because stock returns are more volatile, then when you're trying to correlate anything with price movements, it becomes more of a challenge. You just can't see things as clearly in the data. That's just one of the challenges of doing empirical research on a volatile data set like stock returns. But going back to that noise, what does that mean? It might mean, I mean it could be anything that's impacting somehow those future casualties. Is that essentially what we mean by noise, or do you mean stock prices change so much so quickly that it's just hard to connect it to anything specific? One analogy is, for example, if you're trying to time something that's in the oven, and say you're cooking a nice souffle for your family, needs to be in there for, I don't, I've never cooked a soufflet, say it has to be in there for precisely 30 minutes. Okay, well one way that you can monitor the passage of time is a sundial. You know, when I was younger, my grandparents had a sundial out in the yard. And that is correlated roughly with the passage of time. The problem is the precision is not there such that it's very difficult to time things to the minute with a sundial. So if you try and use the sundial as an oven timer, well if you're off by five minutes, your souffle is gonna be completely ruined. So that's why you want to use the digital timer on your oven because that is a much higher signal to noise proposition. It is interesting when people start to try to apply this precision in the markets to something that is really, I mean your sundial example is a great one, right? But now let's think about what's the potential downside risk if you get it wrong? In one case you ruin your souffle, and another one you can completely derail your retirement goals depending on how you're trying to use these valuation ratios that we're talking about, as a precise signal on what's gonna happen in the markets. Yeah, there's that effort to time the markets constantly. Constantly. And you always gotta evaluate the downside of of doing that. That's right. But you talked about the valuation, so let's bring that up here. Yeah. And just think about where we are. You mentioned we've had a nice run here in the US for many years. Particularly we see that in, we'll call the large growth stocks, which is made up, you know, largely the mag seven. Those big tech companies have driven a lot of that. So let's bring that up here and compare large growth as an asset class to say small value in the valuations. And I've got my little page here that shows the spread of the valuation between large growth. Your favorite chart. It's my favorite chart for sure. I mean what jumps out from looking at charts of valuations for the US market is their very high currently in the top decile of valuations historically. To your point, a lot of that is driven by large cap growth stocks. You know, that portion of the US market is in that top decile, in valuations. Small value on the other hand has been trundling along, more along its historical norm. So you know it, again, you go back to what can I learn from this? The reason why people do pay a lot of attention to valuations is because the cyclically adjusted price earnings ratio or the cape ratio as people talk about it, has been shown to predict directionally at least future returns. So when they're high, which they are right now, that would imply that expect returns are lower going forward. We're talking about money here, we're talking about wealth, we're talking about the stock market, right? And I think for the most part, everybody wants to figure out how they can accumulate more wealth. I mean let's be realistic, we're humans, right? And everybody's looking for some type of an edge in the market, right? Whether we're talking about cape ratios, we're talking about PE ratios, a lot of the things that we've unpacked on this show. But you kind of have to push yourself and say, you know, there's really nothing that's been poured over more than stock market data. And if there was some reliable, like always reliable valuation metric or something that we could look at that gave you an edge, don't you think that everybody would know it and everybody would trade on it? And that's the hard part is, is you just don't have that many observations around these ratios, and what future returns are, to reliably structure an asset allocation around it. That's a really good point. If it this easy to figure out the direction of the stock market, then why do we see so few actively managed strategies are able to outperform index benchmarks? Yeah. It's like it's strange credulity that one number could have that much power. It kinda reminds me of that movie "Interstellar", where Matthew McConaughey is being told by this principal that his son's test scores to low for him to stay in school. It's post-apocalyptic, only so many people can be in school, et cetera. And he looks at the principal and says, your waist is about 34 and what is your inseam? About 32. Principal says, yeah, why? What's the point? He said, so you're telling me you need two numbers to measure your own rear, but one number to tell me the future of my son? It's the same idea with the market. Well, and if you, I think we talked about this before, if you had that information right, you wouldn't tell anybody about it. You'd just go and trade on it. I mean I'd love to have the secret sauce. I went to ChatGPT, which I think a lot of investors are using more and more to think through, hey, give me an answer around, Yeah. markets, is it overvalued or what should I do with my investments? So here's the question I asked ChatPT. The question was, if stock market has a high valuation, does it mean lower returns in the future? And the answer that he came back with said, oftentimes a high valuation equals lower future returns. And he gave a couple ways to think about that. One is the cap ratio, you just mentioned that. So we talked about that. The other one is this concept of mean reversion. So I'm gonna go back to my chart and this is why I love it. So what you're telling me is, I think what you're saying. When I look at a ratio like this where large growth is bumping up on historical high spread between on a PE ratio, large growth versus small value, and you look at the performance of some of these large growth stocks, let's say the last 10 years, it's so far ahead of what we've seen historically. Does that mean then the reversion of the mean says, well then it's gotta just have lower returns to bring back to its long-term run average. And you're saying not necessarily from a statistical academic perspective. Yeah, this is a testable hypothesis. We've run these experiments in the past when you just look at, based on what the trailing premium has been between value and growth, or even the equity premium stocks versus bills. And then when that has been especially high in recent years, does that tell you anything about what the premium is going to be in the future? And by and large the answer was no. And we did not find sufficient data there. And the valuation spreads themselves, I know that's another thing people look at. So we've been talking about at the market level, the cape ratios at the overall broad market level. But when you look at the differences in valuation ratios between say value and growth, does that have any information about the subsequent value premium? Again, you get into a little bit of a nuanced argument here, which is there is a correlation. So on average the value premium has been larger subsequent to periods where those valuation spreads are wide. But again, you explain so little of the variation and the subsequent value premium that just becomes not really useful in terms of timing indicator. You mentioned opportunity costs earlier. When we were doing this research on trying to time these premiums to see if we could actually do it, a big part of the reason why these experiments were unsuccessful is because they missed out on when the premium was actually delivered. You know if that timing indicator was even slightly misaligned. And again, that's what I think the inherent risk for looking towards these valuation ratios as a input into asset allocation decisions, is you might miss out on the returns when they're actually presented. We often talk too about, so what's the alternative? Let's say you are worried about the market dropping, like what are you gonna do? Right? Just sit in cash. I know. And risk those big years. Yeah. You know, as an investor and you have to have to get that long-term performance. The growth versus value too is an interesting one. And that we've seen it, in the US. I'm gonna focus on the US, and we can talk about outside the US here, but you know, you have seen these large growth stocks perform very well, especially relative to small value. And we were in Chicago last week and putting on the conference, and we got the question which is, hey, has something changed? Is something different this time? Is it the right way to still look at this value versus growth relationship? And the gentleman brought up this, all of this stuff around AI. This is really different this time. He said, I know the late 1990s and the internet were a big deal, but this is completely different. And I mean, how many times have we gotten that question right? And it was interesting to go and kind of unpack it with him. You know, if you go back and say, well let's talk about the introduction of the railroads, let's talk about the introduction of cars, let's talk about the introduction of computers of the internet. I think investors at all of these points in time are kind of making this argument of, well it's different this time. There's a fundamentally different relationship between price and expected returns. How we think about growth versus value stocks. And I'd love to get your take on this. 'Cause the thing I tried to to emphasize with him was you want to think about having logic on why you would expect to see differences in returns. And then you want to have a lot of data to back that up. And if we think kind of the the logic piece of it, I mean that to me is what we're talking about a little bit around this valuation ratio, which is all else equal, lower price, higher expected return, right? And that's kind of how we're thinking about the value versus growth relationship. And then you've got 99 years of data in the US. And then the last point I'll make, and I'd love to get your take on all this is, that this whole thing about value versus growth is really been centered here in the US. 'Cause if you look outside the US developed Ex-US in emerging markets. You've actually seen quite a bit different story around this idea of the premiums last 10 years, correct? Yeah, I mean the value premium's been positive outside the US over the past decade, whether you're talking about developed Ex-US stocks, emerging market stocks. And so you know, certainly some of those new normal scenarios probably would fall apart in the data. But you're right, there's a logic versus data element, especially when it comes to any of these valuation ratio indicators. If you're inferring that expected returns are gonna be negative, that doesn't make any sense. Right. Because for something risky like stocks, there shouldn't be a negative expected return. And so really I think what people are talking about is maybe returns are gonna be a little bit lower, not necessarily negative, but maybe they're gonna be lower. And even then I think to your point, what are you gonna do about that? Like does that mean you're not going to invest in those? If the rate of return is gonna be lower, but still positive, you're probably still gonna want to have stocks in your portfolio. Where might come into play actually is with your capital market assumption. So if you're thinking about planning for retirement, you gotta put in expect your returns to figure out, okay, what is my future wealth gonna be like that I can draw upon for income and retirement? And maybe you reflect a lower expectation for the equity return going forward in those assumptions where I say, okay, if returns end up being a little bit lower than their long run historical average, am I still gonna be okay? But can they go negative? That seems very unlikely on expectations. That's a good point on how you can use it. I mean you're sort of like developing a cone of outcomes that say, you know, returns could be higher than expectations, they could be lower than expectations. And from a planning perspective, in all scenarios, do I think I can stay on track for my goals? That's actually a reasonably good way to use the valuations that we're talking about right here. But again, to try to time it, whether it's in the market, outta the market, or this asset class or that asset class, man, it's just a tough thing to do. Well I think your proper plan incorporates both of those situations. Yeah. Where you have a market where it's below historical averages, you probably got a time period where you did better than average. In fact, we've seen that in the data. Yeah. When you look at the returns of the market, what's an average year? Okay, an average year is way out here, usually really good 20 plus or you know, pretty bad. But rarely does it just center on it's long run average on a calendar year basis. Now one other thing that you brought up, Jake, that I think we should talk about, going back to outside the US. So let's go back to the valuation ratios of the US compared to say developed markets in emerging markets. Good point. Is there anything there that can tell us about that? Where we, again, we see a pretty big spread between the US and developed and emerging. How do we think about expected returns there? Yeah, that's where there's good news for investors. If you're sensitive to this idea of high valuations for the stuff you have in your portfolio, the non-US stock markets are substantially lower in terms of valuation. It's much closer to the historical norm, whether you're talking about developed Ex-US or emerging markets. And so if you think about, okay, in a globally diversified portfolio, that's one way that you can mitigate exposure to the high valuation segments of the market. The other one you were talking about, value versus growth is if you have an asset, alions overweighting small cap value stocks. By definition, those are gonna have lower valuations like I mentioned earlier. They're closer to their long run historical averages. So again, that's another way that you can scale back your exposure to the highest valuation segments of the market. We should also say too, we get a lot of questions of value versus growth. We get a lot of questions around mag seven, and we're not here to say that the outsize returns that we've seen, well first off, if you're in a diversified portfolio, you should be happy you captured those returns, right? Great returns. Pumping your fist. Love it. You captured it, right? It's that you just have to be careful extrapolating these outsized returns indefinitely into the future. And that's the point I always try to get across, right. Here at Dimensional, like we're not saying we wanna see mag seven stocks fall off a cliff or anything like that, you know, because maybe we lean a little bit more towards small value. But the bottom line is, is that you do have a relation between when price does go up, that expected returns go down. And when we have looked historically and we've seen some of these stocks go on really good runs, they do really well relative to the rest of the market before they become the big stocks. But afterwards they tend to have as a group market like returns. So it's all about forming appropriate expectations going forward. I think that's why this topic in our commentary is pretty interesting, because you talk about the mag seven, and saying, hey, on expectation, I wouldn't expect those incredible returns to continue like we've seen them. They're probably maybe going forward the data suggests it'd be more market-like once they become one of those top stocks. But we're also saying I wouldn't expect them to have really bad returns either. No. Because we just don't know. We just don't know. I mean I guess you go back to the data and I think you used the word reliably earlier, and you connect that to the research that's done. You just can't reliably say on expectation is probably gonna be anything different than a long run market return for that. A couple things jump out to me here. I think one important point is what you said is on expectation, having a negative expected return for stocks just doesn't seem rational, right? The stock market prices needs to have a positive return in the forward. I think that's really key. I think the other part of this is know your horizon, your timeframe around owning stocks is two, three years. That's the wrong way to think about it. This is 10, 20, 30, 40 years, right? So keep that in mind with stocks. And then have a plan and your plan knows you're gonna have some ups and downs through that. But what's your alternative? Even if it's below, let's say you don't get a historical 10% return, maybe it's six or seven, that's probably still gonna help you keep on your plan for the long run there. So those are some of the things I think about here today. All right, now with that said, we haven't talked about the emotional part of, I guess, investing, and it is tough to see the value of your portfolio go down. And there's some strategies out there that could help minimize that. It's just in terms of what are they, and then what's the cost that comes into if you do wanna minimize the downside of market performance. So let's talk about that in an upcoming episode, and talk about ways you can sort of bring some stability to a portfolio in the most cost effective manner. Will that work? Sounds fun. Like it. Alright, thanks everybody joining us today. Hopefully that was helpful to think about market valuations. Don't forget to hit subscribe, and we'll see you on the next episode. Thank you.