Is The Stock Market Overvalued?

In this article I will try to answer the question – is the stock market overvalued and teach you how can you check this yourself. 

According to a great book ‘Invested‘ by Danielle Town and Phil Town you only need Shiller P/E Ratio and Buffet Indicator to see if the stock market is overvalued. 

However, I included all the other indicators that I know of if you wanted a second opinion.

Shiller P/E Ratio

Shiller P/E Ratio = Share price / (10-year average inflation – Adjusted earnings)

Shiller’s P/E ratio is different from other indicators because it includes 10-year average inflation and cyclically adjusted price to earnings. 

The current Shiller P/E Ratio is 27.73. Its mean is 16.99, median – is 15.90. Right now it is close to the highest it ever was.

Right now it is the fourth time this ratio has increased by over 25 and every other time market crashed a lot. However, this indicator does not tell us when the market will crash. It might be a week, 2 years, or even 3 years, but it will crash.

If you wish to know more about this ratio you can read a book by Robert Shiller called ‘Irrational Exuberance‘.

Buffett Indicator

Buffet indicator = Stock market cap / Nation‘s GDP

The buffet indicator is the ratio between the market as a whole and the national revenue. This is one of the best ratios you can look into if you want to know where the market stands at any given moment.

• Buffett Indicator is 158% and according to the exponential trendline, 128% would be considered to be fairly valued. 
• According to Phil Town if the value is around 60% then the market is undervalued and if it is over 100% it is overvalued.
• Warren Buffet himself said that if the indicator is near 200% the market is highly overvalued.

According to this ratio, the market was overvalued for 10 years now. In 2009 the Federal Reserve Bank had an intervention of 4 trillion US dollars that stopped the crash from it being worse. Also, interest rates were lowered to 0. 

I believe that Warren Buffet is not holding to his cash for no reason. At the moment it is hard to find good investments. However, it is possible.

S&P 500 P/E Ratio

P/E ratio is calculated by this formula – P/E Ratio = Share price / Earning per share (EPS)

We need to check the historic average P/E ratio to the current P/E ratio of the market.

Currently, S&P 500 P/E ratio is 19.71, the mean is 15.99 and the median is 14.91. This suggests that the stock market is overvalued.

Analysts do not like this metric as according to them the value of the market keeps rising, so it does not show the full picture. However, analysts try to find all the reasons to prove that the market is priced fairly.

S&P 500 Earning Yield

Earning yield = Earning per share (EPS) / Share price

This is an inverse ratio to the S&P500 P/E ratio. Earning yield is 5.08%, its mean is 7.28% and the median is 6.71%. The less Earning yield is the more the market is overvalued.

This means that if you invest 100 USD in S&P500 you could expect to receive 5 USD annually from your investment.

This ratio is not conclusive it simply supports the S&P500 P/E ratio. However, it shows that the market is overvalued, but it has a trend to get back to normal levels.

S&P 500 Dividend Yield

Dividend yield = Annual dividend / Share price

The dividend yield right now is 1.70%. Its mean is 4.27% and the median is 4.23%. This indicates that the market is overvalued at the moment.

When stock prices rise it tends that dividends do not rise as fast. If you want to invest in S&P500 for its dividends then it is the worst moment in history to do that. This ratio was lower only in the 2000 crisis.

S&P 500 Mean Reversion

This ratio refers to a stock‘s price and that it will fluctuate around its average over the long term. So, if the market is above the trend it will fall below the trend and if it is below the trend line then it will rise in the future.

According to the historic trendline with added expected growth S&P500 is currently 27% above the trend. So, it is overvalued at the moment.

Interest Rates

The current United States Fed Funds Rate is 4.4%. It has recently been increased a few times. 

This means that the US government decided to make it more expensive to borrow money and by that decrease spending. They did this to fight high inflation rates. Therefore, the US market will stop growing as much and return to a more sustainable growth rate.

This indicates that we should not expect high growth rates for the S&P 500 as we saw for the last couple of years. There are some speculations that interest rates will rise above 5% next year in the US. Of this, the market should slow down even more.

Bond Returns

The US bond returns started rising recently to 3.8391%. In the past year, it has increased by 2.333%. We have not seen such a high rate since the 2008 market crash. 

This is very concerning as bond returns get higher it will be a better (and safer) investment option than the stock market.

When this happens investors tend to sell their stocks and go to the bonds. Therefore, the stock market will decrease in value as the money from it will be pulled out by the investors who would find alternative investment options.

Right now we are going there and this could be one of the reasons that the market will crash as some people leaving the stock market will cause others to see falling prices and because of fear, they would also retrieve their money from the investments crashing the market, even more, creating the snowball effect.

Yield Curve Inversion

In this table, you can see the difference in interest rates between different U.S. Treasury bond yields.

Normally you would see short-term bonds have lower yields than long-term bonds. However, if people expect a stock market crash to happen you can see (like right now) people buying bonds.

At the start of this year bond yield was 2.17% and right now it is 3.98%.

This graph that it is right is a bad sign for the economy and most likely will lead to a bad market crash in less than 2 years.

Market Capitalization to GDP Ratio

Currently, the whole market capitalization to GDP ratio is 133.2%. However, the ratio for the US is skyrocketing at 193.3%.

If the ratio is below 70% then the market is undervalued. If it is above 125% then it is overvalued. This is very similar to Buffer Indicator except for this count for the whole market.

According to the numbers the market is as overvalued as it can be in the US. By this, we could expect a crash.

Sector S&P 500 P/E Ratios and Shiller P/E Ratios

In the graph above you can see averages from the last 13 years and current Shiller P/E ratios by each sector.

By this, you can see that the Energy sector is highly overvalued and you should avoid it.

However, the Communications services sector is highly undervalued.

When you look at the whole market you see that it is overvalued. However, there are 11 main sectors by which you can make a closer look. As it might be a bad idea to invest in index funds at the moment you can probably still find some good investment opportunities by looking at each sector and looking at companies one by one.

In the graph above you can see the Regular P/E ratio at the moment and the average from the last 13 years. 

Again like with the Shiller P/E ratio you can see that the Energy sector is overvalued.

However, the Communication Services sector is less undervalued than Shiller P/E showed us and in fact, the Basic Materials sector might be the one undervalued.

You can use both of these graphs to guide you in the right direction. However, you should look into each company individually. It is possible that you would find some great investment opportunities in other sectors as well.

Is The Stock Market Overvalued?

To put it simply – yes it is very much overvalued and it probably will crash in less than 2 years according to different ratios.

What you should do with this information? Well, it might be a good idea to stock up on cash or choose a different investment idea than to invest in stock market indexes like S&P500.

By looking closer into each section you can see that not all sectors are overvalued at the moment so you might be able to find some stocks that currently are selling at fair prices.

Also, you could look into my alternative investment section or even keep your saving in cash to wait for amazing investment opportunities when the market will crash.

If you want to learn more you can check stablebread.com article.

Conclusion

We answered the question – is the stock market overvalued and the answer is a hard yes. Especially the Energy sector and we can expect a crash soon.

In general, you would not need to look into all these ratios that were mentioned in this article. It is more than enough for most of us to check 1 or 2 ratios to get the picture.

However, I think it is good to know that they are out there and to know how to use them.

According to the book ‘Invested‘ you only need 2 ratios that are very easy to look up and track if you are interested in what current condition the stock market is currently in.

Generally, you can look up only the Shiller P/E ratio which should be around 17 for the market to be priced fairly, or to Buffet Indicator which should be below 100%. If these ratios are higher than that then yes, the market is overvalued.

Don’t miss new articles by subscribing!