Is the stock market overvalued? In depth analysis.


Is the stock market overvalued? In depth analysis.

After the equity drop, roughly 8% that US markets experienced, TRADEPRO thought it would be about time to address the topic: Is the stock market overvalued? This past summer of 2018, we saw high after high out of US equities, while bonds were flirting with levels of panic and recession. Along with the Fed’s persistence in “normalizing” rates, the question of an dangerously overvalued market was ever present.

In this post, TRADEPRO Academy is looking at some key market valuation indicators. The market to GDP, the CAPE, Price to Sales and ultimately what the Fed thinks. The overvaluation of the stock market should be taken a little more seriously. We will aim to prove that with these following points and historic perspectives. Ultimately this is an opinion and no one can predict when the next crash or recession will come. There are warning signs that the average stock is indeed overvalued. So sit back and enjoy the read.

Is the stock market overvalued?-Market to GDP

The market cap to GDP ratio, or the Warren buffet indicator is what it sounds like! Is the stock market overvalued or undervalued in comparison to the historical average. The “Buffet Indicator” got its nickname when Warren Buffet himself said that it is “probably the best single measure of where valuations stand at any given moment”. Just in 1975, one could buy all the US market stocks for 40% of that years GDP, in 2018 terms, you would need 4 times that amount.

What might shock you is that the S&P 500 is not used in the calculation but rather the Wilshere 5000, because it encompasses all US market stocks. A great overall barometer. The ratio is calculated as: (stock market cap/market GDP)* 100. Meaning if the ratio is over 100% then the stock market is considered to be overvalued.

The chart below is representation of the Buffet Indicator, as you can see the barometer is over 100% substantially. Priced at 140%, using a market cap of $28 622 Bn and a Q2 2018 GDP of $ 20 412 Bn. This is set to produced an average annualized negative return of 1.8%. The 140% reading of the market to GDP ratio means significant US market overvaluation. Its pressing into all time highs that happened in 2000.

 

Graph representing the Total Market Cap vs the GDP (Oct 2018)-Credit Guru Focus

Evidence of Overvaluation-Market to GDP

Interestingly enough, since April of 2013 the 100% marker has been broken and the upside has prevailed. Unfortunately. A fairly value market lies between 75% and 90%. From a historic standpoint, the last times the ratio had a reading over 115% (threshold to significantly overvalued) there has been a severe pull back.

The first major instance happened in March of 2000. Does that date sound familiar to anyone? It was the Dot-Com bubble crash. This is where the ratio almost hit 150% before plummeting back into fairly valued levels. This was helped lower with the horrific impact of the 9/11 attacks in America. The market was overvalued for months on end before it came to a climax and then drop.

The next time the market was significantly overvalued in terms of the Buffet Indicator was in October of 2007, even months leading up to that. This was the start of the bear market in the United States, due to large financial institution failure.

More recently, August 2015, there was a large US market retrace, which brought the ratio down from 124% to 106%. Still in overvalued territory, but was edging back into fairly valued territory.

Its important to note that after each of these substantial crashes, the market value levels entered into fair to undervalued levels. This brings about air of concern as the repercussions could much more drastic this time around. The higher the market climbs into overvalued territory, the more room it has to drop. In 2000, the peak just under 150% came down to about 75%. Literally cut in half.

We cannot predict where the top of the Buffet Indicator lies, but we can all agree that the economy is very overvalued.

Is the stock market overvalued?-Cape

The CAPE ratio (Cyclically Adjusted P/E), popularized by Robert Shiller. So it’s also known as the Shiller P/E ratio. The ratio is under to value the overall market, using real earnings per share over a 10 year period. Using the S&P 500, and historic earnings adjusted for inflation, the ratio is equal to the index price divided by the S&P average annual earnings for the last 10 years.

Using the CAPE ratio, we will explain why we think the stock market is currently very overvalued. The CAPE ratio should be adjusted for dividends and earnings, because if one company would not pay out many of its earnings in dividends. While another does pay out most of its earnings in dividends, this will create problems. Assuming that their valuation is the same, their P/E’s will be very different, causing discrepancies in the CAPE ratio. There are two CAPE ratio charts we want to introduce to you. One without Dividend-Adjustment and another with Dividend Adjustment.

Non-dividend Adjusted CAPE ratio-Credit Guru Focus

The chart above represents the S&P 500 and its earnings not adjusting for dividends. Meaning it might be a bit overstated. The peak of the chart is at 44.2, printed during the Dot-Com bubble. Current the ratio is measured at 31.1 as of October 2018. This is in relation to a mean of 16.90, nearly 85% higher than the historic mean. This overvalues the market grotesquely.

This current CAPE ratio is stagnating a little from the recent 8% drop in the S&P since the beginning of October 2018. The levels are much higher than those during the 2008 financial crisis. Which ensued in a long pull back under the mean.

The REAL CAPE

William Baldwin, over at Forbes created a CAPE ratio that adjusts for dividends. His findings although a little more realistic, paint a very similar picture. Below is a Dividend-Adjusted CAPE ratio chart, that depicts an extremely overvalued market. The ratio is price at 30 right now and the mean 20, adjusting for dividends. This is an overvaluation of 50%. Although a lot lower than the non-Dividend Adjusted chart, is still agrees to the large overvaluation of the market.

Retrospectively, the market valuation can be seen as very overvalued through the CAPE ratio. Depicting the P/E ratio of the S&P 500 over the years, the mean is at least 50% under the current value when accounting for dividends, leveling out company valuations for what they truly are.

Is the stock market overvalued?-Price to Sales

Another market valuation ratio is the price to sales. Which compares a stocks price to its revenue. In this case we’ll be looking at the S&P 500’s price vs its revenue. The ratio shows that stock are very overpriced, and its concerning, since they’re almost as expensive as they were in 2000 when the Dot-com bubble burst.

The chart below outlines the S&P 500 price to sales since 1999. Then Dot-Com bubble peak is above 2.5, while in October 2018, we’re sitting at 2.2. This is dangerously close to that Dot-Com bubble level. This is because the last time the price to sales ratio ventured into this territory, the first ever negative total return decade was exhibited by the S&P 500.

 

S&P 500 Price to Sales ratio-Credit FactSet

Another interesting thing to note is that since the Financial Crash in 2008, we have more than doubled the price to sales ratio of the S&P 500. This can be attributed to lower corporate taxes in America, along with unfavorable employee wages tied in with wider profit margins. The “Fat Cats” eat once again, while Wall Streets sees these margins widening! There is likelihood that corporate taxes will continue to decrease in the future and employees taking jobs that are underpaid. Ultimately leading to a drop in the price to sales ratio that could be detrimental to markets.

The main difference from today’s overvaluation and that of the Dot-Com bubble is the degree through which overvaluation was spread among stocks says one Doug Ramsey (Leuthold Group). Meaning during the Dot-Com bubble, overvalued stocks were concentrated. Now, “the median S&P 500 price to sales ratio for specific companies today’s is more than double than it was in 2000” (Ramsey). This could mean a more drastic drop this time around…

Is the stock market overvalued?-The Fed

As a lot of you may know there has been some disagreement between the Fed and Donald Trump. Trump wants the Fed to stop raising rates and the Fed is doing just the opposite. But not out of spite for Trump but out of general economic concern.

Keep in mind although the Fed can influence the markets drastically, their objective is economic stability. The Fed does believe in the overvaluation of the market, especially in one, Dallas Fed President, Robert Kaplan.

Fed Member opinions

Along with other Fed officials even Jerome Powell who is spear heading the rise of rates to more natural level. Jerome Powell who is more of a Dove, is in favor of these rate hikes for the US economic health. This has sparked more Doves to come forth and make more Hawkish statements, in favor of raising rates. This year alone, rate and economic statements from Jerome Powell have resulted in a $1.5 trillion drop in the the stock market. The fed dubs a little retrace “healthy” for markets and there should be more to come. Historically, the Fed has been very good at valuating markets. Each time they’ve hinted to overvaluation, that year, stocks have dropped. Click here for a full story!

Both Fed’s Kaplan and Powell have said that the Fed will ease of on accommodations for the American economy and market to limit the “excesses” in the growing economy. In other words, artificially inflated. Former Fed Chair Janet Yellen has also gone on record to say that P/E are high, nearing historical highs, which holds concern over the asset overvaluation issue.

A very interesting statement came out of the Fed during the summer months of 2018. “Since the April assessment, vulnerabilities associated with asset valuation pressures had edged up from notable to elevated, as asset prices remained high or climbed further, risk spreads narrowed, and expected and actual volatility remained muted in a range of financial markets.” This is a warning sign from the Fed. They warned everyone about the high valuations in April, but by the looks of it the upside continued. In October 2018, markets have given back the majority of the 2018 gains.

Evidence of Overvaluation-Fed Rates

Finally, we’re going to look at some charts. Why is the market overvalued and is continuing to trend in that direction? It’s because an artificial bubble is forming, let us explain it to you.

We can all agree that stocks are very bullish, as an overall trend since the drop that came in 2008-09. The Fed attributes this to super low rates, and super low credit. There are many ways that these low rates can influence the creation of a bubble. Such as:

  • Encouraging borrowing
    • consumers and businesses
    • leads to more share buybacks
    • leads to increased dividends
    • more mergers and acquisitions
    • cheaper mortgages (property speculation)
    • lower margin for trading
  • Encourages riskier activities (stocks/trading) rather than leaving money in the bank

This leads to the Fed to want to raise rates, to get them to more natural levels. Leading to public outrage and Trump’s outrage.

Below, TRADEPRO has outlined the most recent bubble burst we’ve had in relation to the “Everything Bubble” we’re pumping now. The purple rectangle represents the build up to the Housing Bubble, and the orange rectangle is the “Everything Bubble”. The green line on the chart represents the Fed Fund rate and the blue line represents 10-year treasury bonds.

Fed raising rates and dropping rates

It’s pretty noticeable that years leading up to a bubble burst, both Fed Rates and 10-year bond yields get to extreme lows. This time around has been the lowest they’ve been yet. Although on the rise currently, they have been sideways at lows for 7 years. The stock market drop in 2008-09 was substantial and rates were not as low as they are now. Is this a prelude of what is to come?

These low rates came from the Fed’s attempt to save the drop in 2008-09. Which has resulted in a drastic increase in corporate borrowing and as such. Corporate debt. A 40% increase from the high in 2008 ($2.5 Trillion). The corporate debt accounts 45% of GDP, the worst its ever been.

Can you guess where this money is going? If you are thinking activities that result in increased stock prices, you’re right! From stock buy backs, dividend increases to mergers and acquisitions. This is good for the short term growth, and shareholders, but not so much for the longer term scheme of things.

The Fed has been applying its quantitative easing since 2009 which generates money to buy T-bonds and assets to flood money back into the financial system. This quantitative easing has pressed bond prices higher. The inverse effect of this is lower yields, and indirectly causes stocks to fly higher. Overvaluation of the market! In recent conferences, the Fed has said that they will ease on the easing, seeing the longer term effects of their actions.

The Fed has had an overall effect on the overvaluation of stock prices, but is now attempting to right this wrong and guide the economy and the markets back to normal levels. Although they are getting criticized left, right and center, they’re can prevent a more drastic drop.

Conclusion

The stock market overvaluation can be calculated in many different ways. TRADEPRO has chosen the strongest evidence to represent the stance. The “Buffet ration”, the CAPE ratio, Price to sales ratio, and the Fed all tell a similar tale in the stock market’s overvaluation in different ways. All of these indicators paint a picture that could be more gruesome than that of 2008-09. Conditions seem to be a lot worse than they were a decade ago. We don’t want to cause panic and chaos, but its the reality that the charts represent. That is a main reason for the Fed’s relentless effort to continue to hike rates, an attempt to prevent the worst from happening.

 

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The information contained in this post is solely for educational purposes, and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable to your own financial situation. TRADEPRO Academy is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.