Why Are Stocks So Expensive?

There have been countless discussions of the overvaluation of stocks these days. But one metric has been getting short shrift. And that is supply.

The demand for stocks is going to be high as long as alternative investment vehicles are not as appealing as stocks. Right now the perceived return on stocks is higher than that for most other investment instruments, especially because of the low-interest rate environment. This demand may shift, which I'll get to later. But for now let's table that end of the equation, as demand is difficult to predict and hard to measure.

What I can measure is supply. I'm going to look at float because the conventional measure of how expensive the market is involves earnings per share. Right now the total float of equity stocks in the three major exchanges is 765 trillion shares. Two years ago it was 754 trillion shares. Twelve years ago it was 598 trillion shares. The number of shares available to buy has risen by only 28% over twelve years, which works out to 2.07% per year, and for the last two years by only 1.46%, or 0.73% per year. While the float per company listed has increased, the number of companies on the exchanges has fallen drastically, from about 7,500 companies in 1999 to fewer than 5,000 today. Simply put, US companies as a whole are buying back almost as many shares as they issue.

Now let's compare this lackluster growth to the amount of money that people are investing. It's hard to put a finger on that number, but I'll offer a few points of comparison. The amount of money in circulation has gone up 104% in the last twelve years, or 6.14% per year. The amount of money in institutional money funds has gone up 58% in the last twelve years, or 3.87% per year. The total financial assets of households and non-profits has gone up 80% in the last twelve years, or 5.06% per year. The total amount in IRAs has gone up 141% in twelve years, or 7.61% per year. With demand growing two or three times as fast as supply, it's no wonder the price-to-earnings ratio has risen so high.

The situation is even more extreme if we just look at the float of the S&P 500, which has remained almost exactly the same for over a decade. Between January 2006 and today, the total float has varied between 281 trillion and 320 trillion shares, and its size today--294 trillion--is almost exactly what it was ten years ago--295 trillion. Now consider this: right now the amount of money invested in the S&P 500 amounts to 60% of all equity investments in the three major exchanges. Ten years ago, it was only 47%. By this measure, the supply of shares, relative to the amount invested, has shrunk drastically. And because the Shiller CAPE, which measures the 10-year price-to-earnings ratio of the S&P 500, is the most common measure of how expensive the market is, perhaps the float of the S&P 500 is the best comparable measure of supply.

What are the prospects that stocks will get cheaper in the near future? Here are the possibilities that I can see, most of them unlikely:

1. Changes in regulation could make going private less attractive and going public more, thus increasing the number of companies available for investment.
2. Companies could stop buying back their shares and instead pay dividends, decrease debt, and invest in their futures.
3. Interest rates could rise enough to make bonds more competitive with stocks as investment vehicles.
4. Investors could lose faith in the US stock market and shift their investments into alternatives--bonds, commodities, real estate, collectibles, futures, certificates of deposit, and foreign stocks.
5. Changes in regulation and trading practices could make stocks in foreign companies much easier to trade, and investment in them could become more attractive than investing in US companies.

I don't see any signs of any of these things happening in the near future. And, being a long-only equity-only investor, I'm glad of that.

But there is a sixth possibility: that earnings per share could grow to a level commensurate with investment growth. The median EPS of the S&P 500 has grown 44% in the last twelve years, from $1.95 to $2.82; it hasn't yet regained its peak of $3.00 in March 2015, but it's getting close to doing so, and could surpass it in the next year or two. That would make the stock market somewhat less expensive.

At any rate, considering all this, it's a wonder that stocks aren't more expensive than they are. If one judges by the Shiller CAPE, they're significantly more expensive than they were ten to twelve years ago, but if one looks at other measures--the median price to book value or price to free cash flow of all the stocks on the major exchanges (not just the S&P 500)--stocks were more expensive during the period 2004 to 2007 than at any time since. There's room for prices to rise yet farther and for stocks to get even more expensive, since the low growth in shares shows no signs of accelerating.

My ten largest holdings right now: CAMT, BASI, ULBI, MEIP, ELMD, ATTO, FNJN, VVUS, YUME, NHLD.

CAGR since 1/1/2016: 53%. One-year return: 71%.