Is Valuation Losing its Value?

At the risk of sounding sacrilegious, attention to valuation – while it certainly cannot and should not be ignored – probably should be lessened relative to other important considerations.

The primary goal of every investor is to “Buy Low & Sell High”.  Prior to the 1990s, various valuation tools provided a fairly consistent evaluation of the state of cheapness or expensiveness within the overall stock market.  Gauges which had proved reliable over decades of market action could be trusted to advise whether the stock market was ripe with opportunity, offered just ho-hum returns, or whether its valuation suggested significant downside risks. 

These comforting investment tools began blowing up in the 1990s. Stock market valuations rose significantly above the upper bounds of the old valuation range and have mostly stayed above those traditional ranges ever since.  This put the art of investing into a quandary.   All investors at their root – regardless of whether they are primarily oriented towards value, growth, momentum, technical, quantitative, or sector/style rotations -- are value investors. Nobody wants to buy high and sell low. 

Since these long-standing valuation ranges stopped working, investors have compensated in various ways.   Some have clung to the old valuation ranges believing eventually values within the stock market will return to its old range.   Others have developed “new valuation ranges” based on how the stock market has traded since the 1990s.  And still others have simply downplayed the importance of valuation measures in the investment process since most gauges have, since the 1990s, indicated chronic overvalued conditions compared to traditional standards.  

None of these are great alternatives.  Valuations have mostly been above the old range since for the last 35 years – a long time to wait for a return to old norms.  After more than decades of a permanently higher valuation range, it seems like something new has elevated stock market values.   Adopting a “new valuation range” also has problems.  As we discuss below, the new valuation range since 1990 has far less efficacy in accurately assessing stock market valuation risks compared to traditional valuation metrics.  And ignoring valuation altogether seems the riskiest approach of all.  Clearly, despite a new higher valuation range since the 1990s, the stock market has still experienced nasty “overvaluation” bear markets. 

The decaying proficiency of traditional valuation metrics is an important investment challenge which nobody has yet solved.  For this reason, a discussion of the perils of relying on old valuation tools with new valuation ranges is worthwhile and hopefully enlightening.