Newsletter June 30, 2005

InvestorsFriend Inc. Newsletter June 30, 2005

Is the Stock Market Overvalued at this time?

In 2001 I posted an article on this Site that analyzed whether or not the TSX Index (Then called TSE 300) was over valued or not. Although the TSX was a that time down a sickening 33% from its high of 2000, the article (I think I can say correctly) concluded that the TSX was still overvalued. The idea for this analysis came from an article by Warren Buffett in Fortune magazine. I have recently updated this article (see below) since I think it is useful to know if the overall index is fairly valued.

Over longer periods of time stock investors tend to do quite well. Over an investment lifetime the stock market is a reliable way to become well off financially by investing a reasonable amount on a regular and continuing basis.

However, along the way investors face a lot of ups and downs. Occasionally the broad stock market averages will return spectacular results such as a 30% gain in 12 months or 100% in 3 years. (Broad market indexes in North America include: S&P 500, Dow Jones Industrial Average, TSX index). On other occasions the broad market can drop sickeningly causing, for example, a 30% loss in 12 months. Luckily the gains tend to outweigh the losses and the average return over a period of decades has historically been in the range of 10 to 12% per year.

The usual advice is to refrain from attempting to time the markets and to simply keep a set percentage of investment assets in stocks through good times and bad, to benefit from the long-run average return.

However, some investors may choose to reduce the percentage of their assets that are in stocks during periods when they believe that the general market is either over-valued or is trending down (or both).

The broad stock market indexes have done quite well since the Fall of 2002. For example the TSX index at a recent level of 10,000 is up 68% since September 30, 2002, when it was at 5935. There would also have been another 5% or so return from dividends. Similarly the Dow Jones Industrial Average is up 37% in that time period. It is worth considering if the market has become over-valued, given these strong gains.

The good news is that earnings have also risen very strongly and on a price to earnings basis the broad market averages offer better value then they have in about 8 years. This does not in any way guarantee that the market will not decline in the short term. However, given that the market does not appear to be overvalued, it does seem unlikely that it would plunge dramatically. Therefore, long-term investors should feel reasonably comfortable being invested at this time.

I have recently updated articles that examine the following three questions:

Is the the TSX Composite Index Fairly Valued?

You can see also my original 2001 article that indicated that the TSX was over-valued at that time.

Is the Dow Jones Industrial Average Overvalued?

Is the S&P 500 Index Overvalued?

What Are the Historical Risks and Returns of Stocks Versus Bonds?

I recently updated a detailed analysis of the returns of stocks versus bonds and short-term cash investments. I also analyzed the risks of stocks versus bonds. I used annual return data for the U.S. markets going all the way back to 1926.

Unlike many analysts, I also used inflation-corrected data, since it is not much use to make 15% if inflation is 15%.

My conclusion that stock returns have beat bond returns by a wide margin is not surprising.

However, I also conclude that the data suggest that for longer-term investors, the stock market is not really riskier than bonds is a more controversial conclusion.

You can look at the data and my reasoning and decide for your self.

See the following short and informative articles.

What are the long-term inflation-adjusted returns on stocks versus bonds and cash?

Are stocks really riskier than bonds?(maybe not!)

What is the relative value of the various Sectors on the TSX?

There are 20 different sub-sector indexes tracked on the TSX Web Site. These include Energy, Gold , Financials., Consumer Staples, Income Trusts and more. One way to attempt to analyze the relative attractiveness of the various sectors is to look at the P/E ratios and dividend yields. My new article on the TSX sector valuations has summarized the data and offers some comments on the various sectors.

Many of the sectors look reasonably valued, a few look cheap and a number certainly look expensive.

Interest Rates

The U.S. government overnight interest rate was raised to 3.25% today. This is the ninth straight increase since this interest rate bottomed out at 1.0% in June 2003. From that perspective we would appear to be in a rising interest rate environment.

However, long term interest rates have been in a downtrend. And the market has been expecting that the federal reserve will now stop raising the short term interest rates.

From that perspective it is hard to say where interest rates are heading. The continued decline in long term interest rates has been very good for the stock markets. However, the fear now is that long term interest rates that are only slightly higher than short term interest rates may be signaling a recession ahead.

Given the mixed signals, investors should be somewhat cautious and ready to consider reducing their equity and longer term bond exposures if long term interest rates begin to rise. Also equities would be vulnerable if a recession did materialise.