Is the market undervalued, fairly valued, or overvalued?
To answer that question, you would have to first know which market I am referring to (US, Emerging Markets, small caps, large caps, fixed income, commodities, real estate…) You would also need to determine the set of criteria by which to measure valuation (P/E ratio, PEG ratio, ROIC, ROA, P/S…) You would need to decide how much data you want to include for the evaluation period (50 years, 100 years, 200 years…) Importantly, you would also need to make the assumption that future market valuations would adhere to the ranges observed in the data set. Perhaps, you can see why “experts” routinely disagree about whether a given market is overvalued, fairly valued, or undervalued!
Behavioral Finance theory provides additional reasons why valuation is so uncertain.
An essential element of optimal choice is that it is based on an underlying set of consistent preferences. A range of evidence from behavioral economics suggests that individuals in fact have a difficult time forming consistent subjective valuations. Valuations instead appear malleable and arbitrary, as demonstrated in contexts in which alternatives have attributes that are not easily valued or that vary along multiple dimensions. For example, individuals often reverse their stated preferences when they are given choice attributes jointly instead of separately. Valuations of positive and negative attributes of alternatives differe depending on whether individuals are selecting or rejecting alternatives. And the attributes that individual base their valuations on can be difficult to view as the result of perfect optimization. In one example, individuals tasting wines were found to peg their valuations of different wines–as indicated through brain imaging–to the price of the wine rather than the taste. (Emphasis added)
Perhaps most dramatically, other results suggest that individuals’ preferences can be influenced by external cues that have no plausible connection to subjective value. For example, experiments have shown that reminding individuals of the last two digits of their Social Security number affects how they value goods–individual with higher numbers with tend to value goods more highty than those with low numbers, even while be reminded of the arbitrariness of the Social Security number. Finally, preferences appear to be very sensitive to the way in which choices are structured. The addition or subtraction of alternatives, even irrelevant alternatives, can also lead to preference reversals.
—Policy and Choice: Public Finance through the Lens of Behavioral Economics by William J. Congdon, Jeffrey R. Kling, and Sendhil Mullainathan
Clearly, the valuation game is a treacherous one.
One of the reasons we are so drawn to relative strength investing is because it is such a robust concept. We have archived a large number of white papers on relative strength on our website, which detail the exceptional results achieved by this factor in many different time horizons, countries and asset classes over time. Relative strength investing requires significantly less subjectivity than does valuation. We routinely invest in strong trends that “experts” argue are overvalued. We’re used to it. Sometimes, they get it right. More often, the overvalued calls persist for years until finally they are “proven right.” A more pragmatic, and likely profitable, approach is to simply stay with the strong trends as long as they remain strong.