Figuring out if US small cap & foreign indices are overvalued

[dbenamy]

Hi all,

Short version: How can I tell if US small cap stocks, foreign stocks, and/or government bonds are especially under- or over-valued? Please read the rest before answering "Don't try to time the market!" :-)

Long version:
MMM has a great post "How to tell when the Stock Market is on Sale" (http://www.mrmoneymustache.com/2011/06/09/how-to-tell-when-the-stock-market-is-on-sale/). He seems to suggest comparing the P/E ratio to its historical average, and links to http://www.multpl.com which plots the S&P 500 P/E ratio over time in a couple of ways.

Do you have any pointers on how I can get this data for US small cap stocks, specifically the Russell 2000 index (VB at Vanguard), and for foreign stock markets, specifically the EAFE index (VDMIX at Vanguard)?

Are there ways to tell if government bonds are under or over valued?

I'm interested in these because of MMM's post about asset allocation at http://www.mrmoneymustache.com/2012/02/17/book-review-the-intelligent-asset-allocator/. It suggests that owning uncorrelated asset classes smooths out volatility and maybe reduces risk.

I know a little about dollar cost averaging. If I understand right, I can invest a fixed amount periodically (eg every month) and over the long term, the average price I've paid per share will be below average.

I also know that many mustachians favor periodic investment because it's nice and simple.

All that said, I'm interested to know if there's a good way to tell when these other asset classes are especially under- or over-valued.

Thanks very much!

[KingCoin]

You can use the 10y treasury rate as a decent proxy for interest rates:
http://finance.yahoo.com/echarts?s=^TNX+Interactive#symbol=^tnx;range=my;compare=;indicator=volume;charttype=area;crosshair=on;ohlcvalues=0;logscale=off;source=undefined;

While there's a lot to respond to, I'll make the point that just because some ratio deviates from the mean doesn't mean that the price is "wrong". For instance, high P/E ratios could be justified by an extended period of earnings growth. Low interest rates can mean tame inflation expectations, high risk in other asset classes, or few investment opportunities.

The other problem? Let's say you decide stocks are rich, bonds are rich, REITs are rich, and commodities are rich (which is likely what you'll conclude after studying the data). What are you going to do? Sit on the sidelines in cash potentially for many years while your money loses value like clockwork? The biggest challenge of market timing isn't comparing broad ratios vs historical averages, it's getting in and out at the right time, which is next to impossible.

[KingCoin]

All that said, I'm interested to know if there's a good way to tell when these other asset classes are especially under- or over-valued.

In short, there's no way to know. For every asset class there are brilliant investors who think it's overvalued and brilliant investors who think it's undervalued. If you're able to figure it out, congratulations, because that will make you one of the best investment managers ever.

[dbenamy]

Thanks for the clear reply KingCoin!

[turboseize]

It is entirely possible to figure out if something is over- or undervalued. Not only individual stocks, but also asset classes. The problem is, the markets can stay irrational longer than you can stay liquid (crash) or you can mentally stand staying aside and watching prices go up even further (boom/bubble).

By choosing an asset allocation that fits your risk profile, and maintaining that asset allocation, it doesn't really matter if stocks are expensive or not... When stocks are expensive and bonds are cheap, you buy more bonds, when stocks are cheap and bond sexpensive, you buy more stocks. You will not make that one killer trade, but over time, it will work in your advantage.

There is only one exception: when there is blood on the streets, buy. Even if it's your own blood. These obvious occasions are rare, and it takes a very strong will. 2008 was one of these wonderful occasions. Everybody was scared, I was thrilled. But even then, timing perfectly is nearly impossible. For example, I always tend to buy to early, literally catching that falling knive. Works way better than running away scared and coming back to late, but you have to be brave enough to look at red figures in your depot sheet for a year and remind yourself "it will end well, and at least they're paying me dividends..."
If you cannot stand that, get shaky hands and sell half a year later, your in for a disaster. Even with these great events, you CANNOT time the markets perfectly, only roughly. And that needs time to smooth out.


So unless there is blood in the streets (and you are brave enough and have a long time horizon), choosing an asset allocation and then sticking to it is the closest you can get to buying efficiently.

[dbenamy]

Most of this makes a lot of sense to me. One question- you suggest buying more of an asset class when it's cheaper (in a non-crash situation). Does that refer to something other than dollar cost averaging or rebalancing?

Thanks turboseize!

[KingCoin]

It is entirely possible to figure out if something is over- or undervalued. Not only individual stocks, but also asset classes. The problem is, the markets can stay irrational longer than you can stay liquid (crash) or you can mentally stand staying aside and watching prices go up even further (boom/bubble).

While I tend to agree that it's sometimes possible to spot bubbles, I disagree that it's possible to tell whether an asset class is over or undervalued 90% of the time. Furthermore there's not always a mean reversion. Take a look a Japanese 10yr bond yields:

http://static6.businessinsider.com/image/519347daecad042b44000022-521-325/jgb-1.png

It would have been easy to say in 1996 that a 3% yield was way too low relative to history, and that it's time to underweight bonds. Of course the 10y rate slid to 0.4% as stocks slumped, so that trade would have been disastrous.

Rebalancing a fixed asset allocation is the easiest way to buy assets as they underperform and sell them (or at least not add to them) as they outperform. The nice thing about doing this with rebalancing is that it requires no reading of tea leaves.

[prestojx]

I would echo much of the above. Even if you could figure it out it wouldn't really help you because you never know when the market will have a big day - regardless of valuation.

If you are out of the market on a majority of the important days, your returns will be significantly reduced.

Just build a diversified passive portfolio and rebalance when appropriate. If you do this consistently, over time you will out-perform 90% of the active investors out there.

Buena suerte!