Question:

Good morning Mark

Thank you for your articles, they are often food for thought.

If too many investors put their funds into shares, wouldn’t that result in the share market being heavily overvalued, similar to the way that bricks and mortar are currently so overvalued? What will happen if the market is so heavily overvalued? Will that then end up making shares ‘too expensive’ for many people to buy? So, the same effect that has happened with housing?

Answer:

This is a great question. There are several different angles to consider with this question including why the share market goes up, what role valuation plays in markets and how the housing market compares to the share market.

First it is worth considering why the market goes up. To understand why the market rises it is helpful to consider a hypothetical scenario with several unrealistic assumptions. There is a share market with one listed company. The company has one share which is trading at $10. The company earns $1.

There is only one thing that can make the share market go up. Somebody needs to offer more money for the single share and the owner of the share needs to agree to sell. Nothing else will make the market climb.

If the company earns $100 a share and trades at a price to earnings ratio of 0.1 the market will remain at the same level without a willing buyer appearing. More money needs to flow in for the share market to rise.

This example was simplistic. In real life there are millions of investors buying and selling with a variety of different motivations.

There are individuals saving for retirement and individuals withdrawing funds to pay for retirement.

There are professional investors making decisions on the behalf of individuals, endowments, sovereign wealth funds and pension funds. All of these professionals have different mandates influencing their decision making.

There are companies going public and companies taken private. There are mergers and acquisitions. Companies are issuing shares and buying back shares.

The same principles as my simplistic example apply – for the market to go up more money needs to go in than comes out.

The question the reader is asking is how much money flowing into the market is too much. This is a question nobody can answer definitively. The only thing we can do is make statements about the valuation level of the market on a relative basis.

Valuation measures like price to earnings or price to sales are relative valuation measures. They can serve as a point of comparison and allow such statements as ‘the market is more expensive than it was five years ago’ or ‘company A is more expensive than company B.’

A relative valuation measure can’t tell us if the market or a specific company is overvalued or undervalued. Each investor needs to make that determination on their own.

There is no set market level that will cause investors to collectively decide it is overvalued. As previously discussed, different investors have different motivations. But the market falling does not require consensus. All that needs to happen for the market to go down is more money coming out than is going in. It doesn’t even take a conscious effort by investors to sell. Money will naturally flow out of the market. If buying slows down to a certain level the market will drop.

Some buyers and sellers are making decisions based on rational – if varying - assessments of valuation. Many aren’t. Money flows in from compulsory super contributions. Money flows out from retirees paying the monthly bills.

Short-term traders care little for valuation and are guessing on market movements in the next hours or days.

Often investors tend to develop a herd mentality. When panic starts it can spread. That is very different than a rational consensus of value.

Housing prices differ from market prices

Stock splits, fractional shares, low brokerage and financial innovation like ETFs mean investing is accessible for investors with small amounts of money. It means there is a low hurdle rate for people who want to invest. Prices differ from value but there will always be some way for almost everyone to invest.

Housing is different. Financial innovation and changes in government policy can provide opportunities for more people to buy houses through lower down payments and different types of loans. But in Australia house prices have crossed the Rubicon and no amount of tinkering around the margins changes the reality that at current prices there are far more people who want to buy houses than can buy houses.

Final thoughts

You should worry about valuation levels. They are historically high. But it is also important to acknowledge that there are other factors at play. The economy has shifted from highly capital-intensive industries with low margins like manufacturing to capital light high margin business like technology. There is optimism that AI will continue this trend of higher profitability.

Financial innovation has democratised investing and more people are putting more money into the market. Government and central bank policy has been more accommodative. Globalisation has unlocked new markets. Lax anti-trust enforcement has facilitated larger and more efficient companies. Corporate tax rates are lower. The world is a richer place with more disposable income.

There are many justifications for higher valuations. The million-dollar question is how high of a valuation premium over historical levels is warranted. If the market crashes we can all point out how obvious it was that valuation levels were too high. Everything looks clearer in the rear-view window. It is a little less clear in the foggy present.

Have a question? Write me at [email protected]

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