Is the Stock Market Overvalued?
A reader recently sent me a note asking about the comments from the research team at a major investment house claiming the stock market is “fairly valued.” He wanted to know my thoughts, as an economist, about the subject of whether the stock market is in bubble territory. Rest assured, the answer to the question is quite simple…
Of course, it is!
Based on any number of market valuation metrics, the stock market is significantly over-priced.
So, whether you’re a fundamental buyer of equities or a technical trader, no serious argument can be made to dispel the fact the market is significantly over-priced.
Does this mean investors should take their profits and head for the sidelines?
Surprisingly, it doesn’t. Bubbles last until they don’t. And despite the Fed’s admonition that nobody can spot a bubble, trust me, you’ll see it coming for miles…
But let’s look at the evidence suggesting the market is over-valued.
Cyclically Adjusted Price Earnings (CAPE)
The CAPE ratio, developed by Nobel laureate Robert Shiller, measures the price of a stock index relative to the average of ten years of inflation-adjusted earnings. By smoothing earnings over a decade, CAPE reduces the distortions caused by economic cycles and temporary profit spikes.
The CAPE Ratio can be applied to broad equity markets as well as individual stocks. It is calculated by dividing a stock or index price by the average of ten years earnings on an inflation-adjusted basis.
Historically, the long-term average CAPE Ratio for the U.S. market has been around 16.3x earnings. Periods when CAPE has significantly exceeded this average have often preceded lower long-term returns.
The CAPE Ratio is currently trading at about 40 – a premium of 145.4% over the historic average. Now compare this to the highest CAPE ratio ever recorded for the S&P 500, which hit a peak 44.86 at the peak of the dot-com bubble in early 2000. This remains the all-time historical maximum in the data series stretching back to the late 19th century. This leaves little doubt the market is overpriced.
Keep in mind, this valuation is unaffected by those claiming that new accounting standards have put a downward bias on earnings, such as Wharton’s Jeremy Siegel. Siegel’s claim the 10-year average of earnings is being unfairly penalized by deflated earnings levels from the Great Recession don’t drastically impact current valuations.
Stock Market Capitalization/GDP
A favorite valuation tool of famed investor, Warren Buffet, provides more evidence that the markets are stretched. This valuation metric measures the ratio of total US stock market capitalization (Wilshire 5000) to Gross Domestic Product (GDP).
Buffet claims it is the best single measure of where valuations stand at any given moment in time.
I think he’s right…
The standard measure of Market Cap/GDP is broken down into five categories
- Significantly Undervalued (SU): ratio < 50%
- Modestly Undervalued (MU): ratio between 50% and 75% .
- Fairly Valued (FV): ratio between 75%and 90%
- Modestly Overvalued (MO): ratio between 90% and 115%
- Significantly Overvalued (SO): ratio > 115%
The current value of this metric stands at 223.5% - the highest ever recorded. Clearly, this signal is saying the market valuations are in the stratosphere! So, anyone claiming that a market valuation at more than twice the U.S. economy isn’t overvalued isn’t living in reality – or is hoping to sell you their overvalued assets.
Bottom Line
The U.S. markets are grossly overvalued, as is the U.S. real estate market. Both of these realities are a product of the Federal Reserve goosing the market for decades. .
Keep in mind, though, just because the market is overvalued doesn’t mean it’s time to sell your stocks. Overvaluation can last years, potentially. But markets always return to the mean. Eventually.
