The forward price-to-earnings ratio for the S&P 500 as of May 5 is 17, higher than it has been since late 2003. Many experts suggest stocks by most any valuation metric are expensive at the moment. Should the index’s forward P/E keep rising, profit taking is definitely worth considering.
Others suggest that given the zero-interest-rate environment we find ourselves, stocks are anything but expensive.
“It is logical to think stocks are expensive after such a sharp rally [from February lows], but we still characterize valuations as fair,” LPL CIO Burt White told MarketWatch in late April.
“Two market crashes in a decade may argue for a lower PE vs. history,” David Bianco, chief U.S. strategist at Deutsche Bank, said in the same MarketWatch article from April. “But low inflation, low equity investment transaction costs, low net debt/market cap, and moderate equity return taxation all argue for a higher PE than history. Especially, if real interest rates plateau below history’s average.”
The bulls argue that multiples were lower in other years because interest rates were higher. With nowhere else to invest — or so goes the theory — multiples understandably, are higher.
The bears, on the other hand, believe investors are seriously overpaying for the earnings being generated by stocks at the moment. According to JonesTrading, the Dow 30 made more money in 2011 than they will in 2016, yet investors are willing to fork out almost 60% more for those earnings.
Are Stocks Overvalued or Not?
So, who’s right? Well, for that we have to head west to California to find the answer.
While some investors might look to the CBOE Volatility Index, or VIX, to determine if the S&P 500 is too pricey, Calpers — the California pension fund for public employees in that state — might have recently unwittingly signaled a peak in stock market valuations.
The Wall Street Journal reported April 29 that Calpers was reconsidering its 2000 decision to get out of tobacco stocks. Apparently it hired Wilshire Associates to look more closely at its divested investments to ascertain how much money it missed out on as a result of these divestment decisions.
Wilshire found that those decisions cost Calpers $8 billion in investment gains, with almost half of it, $3.04 billion, as a result of its divestment from tobacco stocks between 2001 and the end of 2014.
Oops.
Calpers got out of these investments over concern that mounting liabilities from lawsuits would put a damper on tobacco stocks but that hasn’t happened. Instead, they’ve gone on a tear, up 309% [MSCI World Tobacco Index] in the 10-year period between 2005 and 2015.
And now Calpers wants in on the party.
“Divestment as an investment strategy presents a challenging conflict for CalPERS, as it often pits social responsibility against our fiduciary duty as outlined in the California Constitution,” said Henry Jones, CalPERS Board vice president and Investment Committee Chair in an April 18 statement. “As a California public agency, we are sensitive to the policy issues surrounding divestment causes. But we’re also obligated to ensure that we maximize our investment returns on behalf of our members.”
Calpers will take two years to study the issue at a cost of $500,000 to California taxpayers. There are two ways to view this potential change in investment policy by the pension fund.
The first argument is that Calpers is fulfilling its fiduciary duty to its pension recipients by examining where it’s falling short in its attempt to meet the future financial obligations to its members. That’s absolutely a good thing.
But there’s a second way to view this, and that brings us back to the idea of whether or not it’s time to sell stocks.
While it absolutely should concern Californians that Calpers is underfunded with only 74% of the assets necessary to meet its pension obligations, it’s equally worrisome that in an effort to breach the gap in funding status, it’s willing to turn a blind eye to the same liabilities that caused it to divest in the first place.
With tobacco stocks lapping pretty much everything else in equities both long-term and in more recent periods and Calpers in need of some fast money, it appears that it’s prepared to change its mind, an act that in my opinion is born more out of desperation than true investment strategy.
Look, there are many different ways to ponder whether the stock market has hit a top. A big one is when retail investors on Main Street start pouring their money into stocks. That pretty much tells you the party is over.
The fact that Calpers is thinking about getting back into tobacco stocks after a decade of market-beating returns tells me all I need to know about where the S&P 500 is headed.
Time to sell stocks?
Well, I’m generally a buy-and-hold-through-thick-and-thin guy so you won’t see me selling. But for those who don’t have the stomach for a bumpy ride over the next 12-24 months, you might want to reconsider your weighting in equities.
The Calpers “sell” signal is real.
As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.
