The stock market has experienced a strong rally of late, with the S&P 500 up over 30% in the previous 12 months and the Nasdaq Composite doing even better, up over 40% over the same period.

Naturally, this strong performance has caused people to be concerned that the stock market is overvalued and is due for a correction. A few community members are concerned the market might even be in a bubble, especially with the strong performance of the technology sector exposed to artificial intelligence.

Market Correction or Crash?

Before addressing a few of our members’ concerns about where the market might be heading, let’s first define a market bubble.

What is a Market Bubble?

A market bubble typically manifests as a rapid escalation in asset prices, driven by irrational behaviour, leading to assets being traded well above their intrinsic value. This bubble inevitably bursts when investors realise that valuations significantly exceed actual worth, triggering a swift sell-off or crash.

The Dot-com bubble is a fantastic example as anything to do with the internet was in vogue and traded at crazy valuations. The Nasdaq Composite rose 5x over a few years, reaching 5,048 on the 10^th of March 2000, only to come tumbling down 78% to 1,114 by October 2002.

Are we in a bubble now?

To answer that question, we need to look closely at valuations, and the most common and straightforward metric used is the Price to Earnings Ratio (P/E), which measures a company’s price relative to its earnings.

Since we are looking at the market as a whole, we will examine the S&P 500 price relative to the earnings of the 500 largest listed US companies that make up the index.

Is The US Stock Market Overvalued?

The S&P 500 has a current P/E of approximately 28.0. Compare this to the 50 year average P/E for the index of 20.5, and it most certainly does seem expensive; however, it doesn’t appear to be a bubble when compared to previous examples:

That said, it doesn’t mean prices cannot go down from here, especially if we look at the P/E of the largest companies making up the S&P 500.

The 6 largest companies on the S&P 500 have an average P/E of 43.1, which is scary compared to the index’s average valuation. It also means that the remaining 494 companies in the index have a P/E of 25.8, still above the average. Therefore, I can argue that the market is expensive, but it is difficult to suggest the market is in a bubble and due for a crash.

Navigating the Current Landscape

Moving forward, I am have two strategic options if I want to invest today:

1. Buy the Index for the long term:

As per last week’s discussion, I can always buy the S&P 500 index and hold it for the long term. If we believe in the reversion to the mean, then the market might go down in the near term, but over the long term, I continue to expect to earn around 11% per annum.

2. Buy QUALITY businesses with P/E values below the 50-year average:

Alternatively, I can invest in businesses with P/E ratios below the 50-year average of 20.5. However, I must exercise caution and conduct thorough due diligence to ensure the selected companies are indeed high-quality investments and not “undervalued” for a reason.

This week, I feel compelled to acquaint those unfamiliar with the cornerstone figure of value investing, Benjamin Graham. Regarded as the “Father” of this discipline, his seminal works, Security Analysis and The Intelligent Investor, serve as indispensable guides for investors. Graham’s principles laid the groundwork for the legends of Warren Buffett and Charlie Munger and continue to inspire legions of aspiring investors.

The Teachings of Benjamin Graham

Graham imparted numerous invaluable lessons, but today, I wish to highlight three that I consider pivotal for enhancing one’s investment acumen:

1.      Invest in the company, not the share price

When we purchase just one stock of a listed company, it is no different from buying the entire business. That one share gives us ownership rights of the company, including a proportionate share of the company’s profits. So we are NOT buying a share but rather a company.

It may seem like I am stating the obvious. Yet, even today, people trade stocks because of their volatility rather than the underlying fundamentals of that business, and even “investors” quickly overlook the basics of a company because they don’t want to miss out on the latest trend.

While there are stories of success trading stock and people retiring early because of  “the next big thing,” there are far more stories of going broke due to the same strategies. Unfortunately, those stories are seldom in the media, posted on social media or spoken about over the dinner table.

If we want to be successful investors, we must understand the company we are buying, how it generates revenue, the costs to run it, and the risks involved. The more we know, the more confident we will be when we invest, and although that doesn’t guarantee success, it dramatically improves it.

2.      Invest at less than it is worth.

Graham, being an investor during the Great Depression, was always acutely aware of the risks of investing in the stock market and how easily fortunes could be lost. Therefore, he believed in investing with a Margin of Safety, which means buying shares in a company at a discount to its true worth or intrinsic value.

In Investing Chronicles above, we discussed the historical average P/E of the S&P 500, which is around 20.5, meaning that, on average, the price of the S&P 500 is roughly 20x the combined earnings of its constituents. If we assume this is the fair value of the index, then whenever the index is trading below 20x earnings, we have a margin of safety. The lower the P/E, the greater the margin of safety.   

Similarly, for a company, once we have analysed the business and its economic drivers, we should be in a decent position to derive an estimate of its intrinsic value. If we believe the company to be worth $100 million and the market currently values it at $150 million, why would we purchase shares?

However, the opportunity is evident if that company has a current value (market cap) of $75 million. More importantly, buying it at $75 million provides us with a safety net because our calculations might be off (almost guaranteed they are), and the company’s actual value could be $80 million. Of course, the actual value could be $120 million, but you get the point!  

3. Let the Market Come to You

Besides “ Margin of Safety”, Graham is also famous for coining the term “Mr Market”, referring to the bipolar nature of the stock market.

In the stock exchange, as with all things involving human beings, emotions get involved, and one could argue that when money is involved, we get highly emotional. The higher the emotional charge, the higher the capacity to act irrationally.

Euphoria will likely occur when share prices appreciate and money is made. Market participants throw caution to the wind during these times, feeling nothing can go wrong. As a result, investors overpay for assets. We can see this currently, at least in my opinion, as certain tech stocks are valued as though the stars have aligned

Of course, the opposite is true too, when fear takes grip. During these times, irrational, pessimistic market participants convince themselves that they will lose all their money and sell while running for the hills, screaming, “The sky is falling”. During these times, valuations can plummet to illogical lows.

Our goal is to remove our emotions when investing.

Investing in the long term is a fantastic strategy because it allows us to ignore short-term market noise and fluctuations, especially if we understand what we have bought. We are in a hugely advantageous position to take advantage of Mr Market, buying when fear is at its peak and selling to the overzealous buyer.

Summary

So be more like the Father of Investing:

1. Know what you are buying,

2. Know what it is worth, and

3. Only buy it when you can get a substantial discount.

If you can master the above, you are well on your way to being better than most.