Indicators have been part of investing for nearly as long as the stock market has existed. Each indicator attempts to define the value of the market better so investors can gain an edge (or at least make a good investing decision). Yet every indicator has its limitations.
Over time indicators can become more or less relevant. What worked before works less as the economy and markets evolve (and companies learn to game the system). An indicator gaining relevance happens rarely, often by chance.
Some indicators stand the test of time. The price/earnings (p/e) ratio might be the most recognized indicator. People often talk about the p/e ratio as a way of describing an over- or under-valued market.
Indicators can also evolve. The p/e ratio has its limitations. Large charge-offs by a few businesses can cause the ratio to swing wildly. To smooth out the bumpiness in the p/e ratio, the Shiller, sometimes called the Cyclically Adjusted PE Ratio (CAPE Ratio), was devised. The Shiller Ratio takes the last 10 years of inflation adjusted earnings in calculating the Shiller ratio. A surge in corporations taking large-write-downs of assets does not whip the Shiller as much as the p/e ratio which only uses the past 12 months of earnings.
Rather than discuss every indicator for the market, we will focus on how accounting practices used for a very long time can distort the true value of the market, thus causing market indicators to give less than accurate readings, especially considering the massive changes in the current economy. As public corporations attempt to game the system to make it seem their business should be valued higher, investors can get caught overpaying for stock in a company. This can seriously harm investment results.
Cooking the Books Legally
Before the computer and the internet became so entwined in our lives I ordered annual reports from numerous companies and received a hard copy. Several filing cabinets in my office were filled to the max. Annual reports were my way of unwinding after a long day. They came in handy when I did research and wanted to see long-term data. Now I hoard annual reports in digital form. Or you can look them up online.
I bought some shares of Intel (INTC) in the early1990s. There was a small dividend which I enrolled in a dividend reinvestment plan (DRIP). Now that I owned some shares I needed to do more research to determine if I was going to go all-in.
I made small additions to my holdings periodically. Years passed as I kept studying the company.
Intel was a leading name in computer chips. I liked that. They also bought back a lot of their stock. A good sign. They used an interesting strategy in buying back their stock. They sold put options. They collected a premium. If the stock went up they kept the premium and did it again. If they stock went down they were assigned the stock, effectively buying back those shares.
Still, something nagged my mind. Something just did not seem right with Intel.
Nearly a decade of ownership had me at a crossroads. My holding were still small, around 1,000 shares. Then I decided to change the way I researched the company.
I knew Intel was buying back a lot of their stock. I knew they sold put options to collect premiums that could be used to fund stock purchases. Intel collected so many premiums they actually broke it out near the beginning of their annual report back then. Option premiums moved their earnings needle.
I started to wonder, How many shares have they bought back in the past decade? At the doorstep of the year 2000, tech companies were flying. Y2K was in the air. Was Intel a screaming buy, a hold, or a loud sell?
It was then that I noticed something unusual. Intel had used all their operating earnings and more buying back their stock during the 1990s. And a quick look at my old annual reports told me a chilling story. Adjusted for stock splits, Intel had more shares outstanding at the end of 1999 than it had in 1990! But they used all their operating earnings for a decade buying back stock! What gives!
The Lie
Intel did nothing illegal or even wrong. They reported all the data you needed to know the truth. They were abundantly clear on what they were doing. They sold put options for premiums and used the same strategy to buy back massive quantities of their stock.
BUT!
They were using all that repurchased stock for stock options to employees. Instead of paying employees solely in wages, Intel made a large part of many employee’s pay package in the form of stock options. At a certain point employees vested and received the shares. That is why Intel had to keep buying their own stock on the open market like crazy.
The best part is most investors did not notice what was really happening. Stock options to employees appear in the footnotes of the annual report. Companies usually use a formula (Black-Scholes) to determine the cost to the company. But most of all, these payroll expenses did not show up in headline earnings reports. The p/e ratio looked better than reality warranted.
And before you wipe your brow thinking those days are past, think again. Nearly all, if not all, public companies award certain employees stock options. The only difference with Intel is the level it was taken to. If the real cost, by my calculations, were included in reported earnings Intel would have made little to no profits in the decade of the 90s.
As the year 2000 came in I sold my Intel shares. It was luck that the stock was riding high at the time. A few months delay and it would have cost dearly. Take a stock chart of Intel from January 1, 2000 to today and compare it to the S&P 500. It isn’t pretty. Spoiler Alert! Intel is about where it was 25 years ago. The S&P did better, I think.
Investment Research in the Modern World
This is only one way reported earnings have been skewed. Accounting rules allowed Intel to do what it did. And stock options are a powerful tool in attracting talent at public corporations. Therefore, the practice is as common as ever.
It is not all bad. Used properly, awarding employees with stock options is one of the best tools in gathering the right team to move a company forward. Investors do need to pay attention to the details. Read the annual report footnotes. Then apply math most don’t. How much of earnings go to buying back stock? How many shares are still outstanding? If too much of reported earnings go to buy back stock, yet the number of shares outstanding is not moving down meaningfully, there might be some issues you best consider before investing.
Is the Market Overvalued?
As I write the S&P 500 is at historical highs. The broad market is richly valued compared to the past 100+ years. And that is assuming reported earnings are not getting diluted. We know the same thing was not happening in the 1920s before The Great Depression. (They had different accounting issues then.) Earnings were not diluted the way they are today. That makes today’s valuations even more out of line with past valuations.
Who knows where the stock market will go? We do know that valuations at record highs have led to lower performance over the following decade. I am the last guy to tell you that it is a lock (that stocks underperform from current levels) in the current environment. Nothing is ever a lock. This time could be different. It never has in the past, but this could be that time.
And while the broad market indexes are making record high valuations by some measurements, that does not preclude individual companies from outperforming. There are always opportunities. Always. Sometimes there are fewer. I believe this is one of those times. sometimes there is an abundance of opportunities. That day usually follows shocks to the market. Be prepared to act.
What Can I Do?
It isn’t an automatic sell when valuations are high. Valuations can stay high for a long time. They can also stay low for a long time. There is no law that says the stock market must revert to some hypothetical mean.
It isn’t market valuation that determines your investing actions (or at least it shouldn’t). If you are investing in your retirement account, stay the course. Over long periods of time the risk has been being out of the market, not avoiding market breaks.
The younger you are the more you need to dollar-cost-average into the market. Work retirement plans are perfect for doing this. If you do it manually, don’t stop based on market levels! You are more likely to miss more gains than losses avoided.
It comes down to age and how near you are to retirement.
How much should you keep in cash? If you are near retiring you want to keep more in cash. A richly valued market allows you a good price when moving from stock ownership to liquid money markets. A couple of years spending is a reasonable amount when you approach retirement. Perhaps up to four years of spending, or even five, is more appropriate once retired. This allows you to ride out just about any market decline without changing your lifestyle or forced to sell to keep up that lifestyle.
If you are not near retirement you need some liquid funds in either a money market or guaranteed bank product like a CD for emergencies. A layoff from work or reduced hours can damage a family budget. With six months or so liquid you have resources to weather economic winds.
You also need some liquid funds at any age for life’s emergencies. An auto repair or replacement is a prime example. Most people need to build 6-12 months of spending in liquid and stable investments, regardless your age. That is step #1.
The goal is to weather market and economic insanity. We know the stock market will have another wonderful pullback at some point in the future. We know recessions and job loss are part of the life experience.
Success favors the prepared. Have a plan. Build reserves based on your circumstances.
And please, please, don’t borrow to buy more because the market looks so good when overvalued. That is the best way to stay poor. So pass on that.
