The Stock Market's Valuation is Getting Ridiculous...

It's no secret that the stock market is currently overvalued, but what should we as investors do about it? I have a look at this chart, which is tracking a metric called the Shiller PE. This metric was created by the American economist Robert Shiller, who subsequently was awarded a Nobel Prize for his work on understanding market efficiencies, bubbles, and the importance of investor psychology in driving economic outcomes.

The measure is a reasonably simple one; it's also called a cyclically adjusted PE ratio. What it does is it compares the average inflation-adjusted earnings with the S&P 500 of the last 10 years with the price of the S&P 500. Long story short, it's a long-term conservative price-to-earnings ratio for the S&P 500. It means when stock prices are high but the earnings have been low, the Shiller PE rises, and when the prices fall or the earnings rise over time, the Shiller PE comes down.

So it tells us what the average investor is willing to pay for the S&P 500. For example, in August 1982, the average investor was willing to pay out 6.64 times the earnings of the S&P 500 as a share price, whereas at the start of 1996, that accepted price had rocketed up to 26 times earnings. The market since World War II has sold between 10 times earnings and 20 times earnings. If you look at the Dow Jones or the S&P 500, if you add up all the companies and take the earnings, you see there's a relationship, and it follows.

McDonald's earnings have been terrific the last 30 years, and the stock's been terrific; there's a direct relationship. So, the earnings of the S&P 500 have been between this range of 10 and 20. We were just about to go over the 20, which is the high end of the PE range. There wasn't a lot of room left. 20 is the high high it should ever be, right? It's been over there only a few times ever over 20. So, as Peter says, the market will typically stay within these Shiller bounds of 10 to 20.

Well, guess what? Today, the story is much, much different. Currently, the Shiller PE sits at a whopping 35. It's only been this high around three other times in history: 2021, 1999, and 1929. So correlation does not equal causation, but the market is pretty hot.

So what do we do now? I recently made a video on what passive investors should do, and we turned to the father of passive investing, Jack Bogle, to steer us in the right direction. But what do we, as value investors, do? Well, why not turn to one of the best who ever did it—that being Peter Lynch—to guide us. In Peter's opinion, there is no easy way out of our predicament, but there are a series of steps you can take to make sure you're making great investments, remembering there's a difference between finding a great company and a great investment.

A big part of doing it well is simply turning over more stones. Some people know a lot about this; 10,000 public companies, a lot of them are very attractive, no one's following, and there are lots of people following IBM—companies that nobody else follows, right? I'd like to go to see companies with unions or companies in trouble or companies that no one looks at—hotels that had nice beds. Yeah, you have to look at a lot of them.

You pay your wife. I remember this story, okay? You got Per One Imports; my wife found that one too. But you have to look at 20 to find one. This has been a big trend that I've noticed with value investors over the last few years. What you get in overvalued markets is all the most followed stocks rising to the moon—the big companies in the top 50 of the S&P 500: the Coca-Colas, the Amazons, the Microsofts.

These companies have thousands of analysts or just people scrutinizing and investing in them, which makes it very hard for the stock to become a good deal. The Warren Buffetts or the Monish Pabrais or the Michael Burry's of the world can see this happening, and if you look at what they've been doing, they've started looking to less-followed stocks or less-followed markets to find their deals. Monish Pabrai has famously been buying stocks in Turkey and India because they're so cheap and they're less focused on.

Michael Burry's largest position is in a tobacco company—an industry that these days has fallen very much out of favor with most investors. One of Charlie Munger's final investment decisions was to look abroad to China to find value. One of Warren Buffett's most significant investments of the last few years has been a diversified bet on five Japanese trading houses. In these conditions, stock picking simply requires more work, and you need to be on the lookout for something other than the run-of-the-mill tech behemoths that hold up the market.

Well, I think looking for something different, looking for something that's a good story. I mean, who would have guessed TJX, a local company, would have gone up 50 fold? Or Stop and Shop would go up 10-fold? Or Analog Devices or Nvidia. I couldn't pronounce Nvidia! So you have to find a company that's either a turnaround or a company that's going to grow.

And we've seen both those categories of stocks perform well over the past few years. For example, coming out of the pandemic, everyone might have been getting excited about the companies benefiting from the lockdowns—for example, Amazon or Netflix. But you would have been better off looking for companies with amazing long-term prospects that had just been beaten down with the rest of the market panic.

So looking at strong companies that fall into that category of a turnaround is definitely one way to get through the times when the market is generally expensive. That's more of a value investing approach. The other option, in Peter's opinion, is to just find the companies that have a really strong growth story emerging and also have a really long runway. Peter mentioned Nvidia as the most obvious current example.

Now, I cut the clip short, and he did explicitly state that he's not saying these companies are buyers now. But if, say, a few years ago you had a strong understanding of programming computers or semiconductor manufacturing, and you saw Nvidia's long-term sales runway with these big tech companies all buying GPUs for their AI projects, you could have made a lot of money backing that story despite the market and most stocks being generally overvalued.

So Peter Lynch says to focus on turnarounds or growers, but really what he's saying is stick to those two tried-and-true investing methods of growth and value investing. But, of course, the important thing with these approaches—particularly in overvalued markets—is that you absolutely stay within your circle of competence.

You don't go messing around with stuff that seems interesting but you don't understand. People, they're investing in individual stocks—it's sad. They're careful when they buy a refrigerator or an airplane flight or they're careful with the money, and they'll hear, put a stock on the bus and they'll put $5 or $10,000 on it—they have no idea what they do. So you really got to be careful—look at the company, look at the balance sheet.

What is the reason the stock should be higher? The sucker's guppy is not a good reason. So you have to look for companies that sit outside of what Wall Street follows. You have to look for the outliers that do have a decent growth or a turnaround story, and importantly, they have to be businesses in your wheelhouse.

You know, for me, I will probably never own Nvidia because I don't get the industry. I get social media; I get entertainment-based companies. I understand the attention economy quite well. Now, to an extent, I understand computers, but I don't know how to code. I don't know how AI really works, and I don't know how to manufacture computer componentry—that's for damn sure. So Nvidia is simply outside my circle of competence.

So, in my opinion, you really have to stick to what you know, particularly in these overvalued markets, and that will really be the difference between you simply buying great companies or making great investments. You have an edge! I mean, what if for the last 30 years you worked in the restaurant industry? You would have seen Taco Bell, you would have seen Saros, you would have seen Pizza Hut, you would have seen Chili's.

You've seen these companies doing very well; you should have bought those instead of trying to buy biotechnology you know nothing about. So we have to be really strict with our circle of competence, especially now when there are limited options. And the other thing we need to be strict on is valuation. Because finding good opportunities is so difficult, it can be really easy to let your valuation slide and jump into something super expensive simply because you aren't finding anything else.

But remember, as I said before, there is a difference between a good company and a good investment. We have to ensure that there is still considerable upside and considerable safety at the current share price to go ahead and buy in. Just think of this as being; you say to yourself: I think this company is going to earn something in the future. If it's already discounting, if it's selling at a huge multiple, you say it's already had to work, and then it's only going to stay even.

So you have to say to yourself: If I'm right, how much am I going to make? If I'm wrong, how much am I going to lose? That's the risk-reward ratio in stock shop. We talk about it; if I'm right, I hope I'm going to double or triple my money. If I'm wrong, maybe I'll lose 30-40%. That's a favorable ratio. You say if I'm right, the stock's not going to go up; it's already discounting terrific things.

If discounting terrific things are already in the stock, I don't want to know.

Okay, to go a little bit deeper on this, I want to use Nvidia as an example and run a standard discounted cash flow model on it. Now, I'm not going to get into the weeds with this, but I will say if this is something that you would like to learn, you can definitely check out "Introduction to Stock Analysis" on New Money Education. Over there, I teach three valuation methods, and the discounted cash flow method is one that we go very deep on.

But having said that, take a look at Nvidia: Over the past 10 years, it has been growing at a compound annual growth rate of between 30 and 50%, and those numbers are very much thanks to their recent surge in sales. Now, that's an insane growth rate, but the crazy thing is, at the current valuation of around $3 trillion, the market is expecting the company to maintain that 30% growth rate for the next 10 years as well.

To make the investment worthwhile today, at a 30% annual growth rate, and assuming we can sell the business in 10 years at 25 times free cash flow—which is still generous—the intrinsic value comes out to $3.1 trillion, with no margin of safety. That is insane, and it means that everything has to keep going gangbusters for the next 10 years just to make this an okay investment.

But have a look at this: If the company can't maintain that level of growth and only grows at 20% per year for the next 10 years, you can expect the stock price to roughly halve. If the company grows at 20% annually and in 10 years sells for 25 times free cash flow, we can expect the market cap to be around $1.5 trillion at full retail price. So, despite Nvidia definitely having a story and being a wonderful business, as Peter Lynch says, if it has to work, then you're only even—he doesn't really want to own it.

So getting back to investing in overvalued markets, you need to be patient. You need to turn over a lot of stones; you should be on the lookout for turnaround stories or undiscovered growth stories, always staying inside your circle of competence. You also need to be careful on the valuation side.

But with that said, there is one more thing I wanted to cover in this video, and that is the subset of us investors that get a little bit of paralysis in overvalued markets. To an extent, that's also me. A lot of the big companies in my own circle of competence are quite expensive, and with everything going on in my life, sometimes I just look at my watch list and I think, what’s the point? All these stocks are probably overvalued.

The market looks like it's forming into a tech bubble like we saw in 1999, which may burst at some point. And even here on the channel, we've seen big names in the space like Ray Dalio, Jamie Dimon, Warren Buffett, Howard Marks, etc., talking about how there are so many risks in the market right now. Then to compound it all, you see the media talking about risks of recession, supply chain issues, interest rates, inflation, geopolitics, and you just put it all together, and it makes you kind of just want to sit on the sidelines.

But ultimately, that is a bad strategy. There's always something to worry about. I'd say, my over 50 years of doing this, I think I'd be worried if there was somebody who didn't bring up something to worry about—that's the nature of business. There's always something to worry about; and this is so true when it comes to investing because the media always gets clicks from fearmongering.

Tuning into mainstream media does give you a warped view of the markets. No matter the market conditions, you'll always be able to find someone's opinion that will scare you away. But the truth of the matter is that nobody knows what will happen in the short term.

So it's far smarter to block out the noise and keep going as you always have. Well, we've had 13 recessions since World War II, and we've had 13 recoveries. Maybe we're going to have one. I'd love to know the future—it would help! I’d be a better investor. I'd pay five extra dollars for next year's Wall Street Journal; it would really help.

I cannot predict the future, and because of that, if you decide to stay away from investing your money altogether, you have to be prepared for the potential outcome that the market actually continues on its merry way, and you miss out on the returns. That's what happened through the late 2010s, right? The market looked hot, but it just kept roaring.

So we definitely don't want to put ourselves in a situation where we miss out on the stock market's returns. And there's actually this really cool calculator that Fidelity has on their website—coincidentally, the same fund that Peter used to work for—and it shows you what happens over time if you miss the 10 best days in the stock market.

You can see here that if you're in America and you invested 10 grand back in 2003 but missed the 10 best days from then until now, your portfolio could have been worth 78 grand, but instead, you get just 37,000. So as the chart suggests, timing the market in the short term really doesn't pay off.

What you're saying to people today about the future of the market over the near term is, what's your feeling? We can take a coin out and flip it. I have no idea what the next thousand points are going to do. The next 6,000 points are going to be up; the next 14,000 points are going to be up; the next 20,000 points are going to be up. But you don't know where the next thousand is going to be. It could be down; it could be up. Nobody does.

And it's futile to try and guess it. Corporate profits will be a lot higher 10 years from now. They'll be a lot higher 20 years from now—that's what you could rely on. And that's really the game: buying great companies at reasonable prices and looking long-term.

So if I had to summarize Peter's advice when it comes to investing during overvalued markets, it isn't about waiting for a crash, but it isn't about just sending it and buying companies willy-nilly either. It's about being patient, staying within your areas of competence, turning over a lot of stones—especially when it comes to the less-analyzed companies—keeping an eye on the turnarounds or the growth stories, and also ensuring that when buying these stocks, you are setting yourself up for success.

I.E., you're making sure the price you're buying in at still makes sense for what the company might be able to give you over the next decade. And I will give his book a shout-out: If you ever want to learn his strategy in more detail, "One Up On Wall Street" has got to be one of the best stock market books ever written, and I definitely recommend you check it out.

Also, a quick reminder: If you want to learn how to implement the strategy, including reading financial statements, analyzing moats, management teams, and learning three valuation techniques, remember to check out "Introduction to Stock Analysis" down below.

But with that said, guys, hope this video helps you out on your investing over the next year or two. And with that said, I'll see you guys in the next one.