Is the stock market overvalued? That is the trillion dollar question. At a time when indexes are hovering near all time highs and corporations like Apple are achieving valuation milestones on a daily basis, it’s difficult not to ask this question. The answer, however, is not entirely straightforward.
Let’s consider what traditionally drives valuation. Regardless of which valuation methodology you follow, growth tends to be the common denominator in most valuation exercises. If growth is on the rise, valuation should increase. In turn, the stock market should increase. Growth at the macro economic level pushes company performance to new heights. When the economy is growing, people are buying more products which enhances a business’s financial performance. Assuming expenses remain stable, a company’s profits should increase. And if profits grow at a reasonable rate, so should the company’s value. To put in plainly, when you sell more you earn more. Assuming this to be the case, your company should increase in value. You don’t need to be Gordon Gekko to figure this out. If companies across sectors and industries are selling more and earning more, the stock market should continue to rise.
For several years the perception has been that macro economic changes have created an environment conducive to strong economic growth. And with strong economic growth should come increased corporate profits. Corporate tax cuts and low unemployment offer the possibility for stronger corporate profits which has fueled the a multi-year stock markets ascent. Yet some argue that tax cuts have yet to take effect and the outcome of these cuts has yet to be determined. Additionally, the longer trend line for the stock market increases largely correlates with low interest rates. Cheap money has enabled corporations to boost productivity and profits for the last decade. History has shown that cheap money can’t last forever. When this trend reverses, so will the cycle of profit growth.
Finally, the specter of a global trade war has placed major corporations on edge. Managers are positioning themselves for slower growth should costly tariffs increase, which will undoubtedly hurt corporate profits. And if profits drop, so will valuation. Since stock market investors tend to be forward looking, they tend to place their bets on how a company will perform in the future. If the outlook for growth is robust, prices will move higher. On the other hand, if growth appears to wane, that won’t bode well for stock prices.
Now, back to our question. If corporations continue to grow at a healthy pace, markets can move higher. If, however, factors such as rising interest rates, poorly implemented tax cuts, or trade wars derail this growth, you can bet that our beloved rising stock market will reverse course.
Reuben Advani is an entrepreneur, executive, and author. He founded and later sold a financial training company that offered mini MBA courses to corporations and law firms worldwide. He is also the author of Financial Freedom: A Guide to Achieving Lifelong Wealth and Security. He holds a BA from Yale University and an MBA from the Wharton School.