Newsletter April 9, 2018
U.S. Stock Market Valuation
Despite recent declines, the U.S. stock market is not trading at bargain levels and based on conservative assumptions appears to be over valued. My recently updated analysis of the valuation of the S&P 500 index suggests that the S&P 500 index could be 27% over-valued based on conservative assumptions.
On the other hand, keep in mind that the best judgment of the aggregate of all stock market investors is ALWAYS that the S&P 500 (and in fact every investment) is already at fair value. If market participants in aggregate or on average thought that the S&P 500 or any other investment was overvalued they would bid the price down.
My own view is that in order to justify the current value of the S&P 500 index I would have to forecast that the current high P/E ratio will remain high or that earnings growth will be higher than levels which I would be willing to assume.
Predicting the Canadian Dollar
Most Canadian investors are interested in knowing where the Canadian dollar, which currently trades at 78.7 U.S. cents, is headed.
The best guess of the currency market participants in aggregate is that the Canadian dollar will remain at about its existing level. After all, if there was a consensus that it should move higher or lower then the market participants would immediately push the dollar to the anticipated level. Technically, such investors would also adjust for the difference in inflation and/or interest rates between the two countries. But for all practical purposes the best judgment of the market is always that the Canadian dollar trades where it should trade and should not be expected to move much until and unless new unexpected information and developments come along.
Of course, not every market participant has the same view. There will always be observers and analysts who think it is obvious that the Canadian dollar will rise. And there is always another group of market participants who are equally convinced that the Canadian dolalr will fall.
For Canadian investors, my advice would be to allocate a certain percentage of a portfolio to U.S. investments. The particular percentage is hard to arrive at and depends partly on whether an investor plans to ultimately spend some of their savings int eh U.S. Efficient market theory would likely suggest an allocation of at least 30% to U.S. investments for diversification purposes. Then, if the Canadian dollars falls and pushes the U.S. allocation higher than the target level some funds could be transferred back to the Canadian portfolio to re-balance. In this way an investor would tend to by selling U.S. dollars as the price in Canadian dollar rises and buying as the price falls.
How to divide a portfolio between safe cash and relatively safe bonds and riskier equities is a very important but difficult decision. There are a series of articles on this site where I have addressed that issue.
How The Stock Market Works
Review this article for a discussion of how companies raise money on the stock market and the nature of the secondary trading market and why it is fundamentally difficult to beat the average market return.
April 9, 2018