Since the stock market bottomed in 2009 (during the Financial Crisis), the US stock market has enjoyed an unbelievable ride higher with very few major corrections. In fact, from the March 2009 bottom, the market is up over 700%. With such a great, “seat of your pants” type of ride over the last decade, it might make sense to take a step back and assess where we are now.
To offer some perspective on the stock market - below are five measures that illustrate where market valuations currently stand:
1. S&P 500 Price to Earnings Ratio (P/E Ratio)
The S&P 500 P/E Ratio measures the combined price of all 500 Standard & Poor constituents against their aggregate earnings-per-share. Its latest reading is 25.39, which means investors are paying just over $25 for every dollar of earnings.
The P/E ratio has historically been below 20, so this would suggest that the market is currently over-valued. However, when we look at the forecasted P/E, it is currently 21.87 which is more inline with historical averages.
In addition to this: Lower interest rates can justify higher valuations, all else being equal - there is an inverse relationship between interest rates and valuations which I will write about in the future.
Indicator Conclusion: Mildly Overvalued
2. S&P 500 Cyclically Adjusted P/E Ratio (CAPE Ratio)
Similar to the P/E ratio, the CAPE ratio divides the S&P 500’s current price by its 10-year earnings, adjusted for inflation.
Why adjust the traditional P/E Ratio?
By using a 10-year period, this tends to smooth out year-to-year fluctuations in earnings which can be somewhat volatile over shorter periods of time. The idea is a higher CAPE ratio could reflect lower future returns, whereas a lower figure would indicate higher returns. The CAPE Ratio was developed by Noble prize winner Robert Shiller of Yale back in the 1990’s; however, this idea is not exactly new, Benjamin Graham (the father of value investing) and David Dodd recommended using 7-10 year averages in their seminal 1934 book Security Analysis when using valuation ratios.
There is some research that shows over long periods of time this ratio tends to predict future long-term returns fairly well. However, the CAPE ratio isn’t expected to predict what the market might do over short periods of time. Having said that, large spikes in the CAPE ratio have often preceded recessions, and it’s important to realize that the metric is currently approaching its highest level on record.
The CAPE ratio currently stands at 38, which is 26% higher than its 5-year average, 40% higher than its 10-year average, and more than double its 100-year average.
Indicator Conclusion: Significantly Overvalued
3. The Buffett Indicator
In 2001 Warren Buffett said that US Market Capitalization as a percentage of GDP is “probably the best single measure of where valuations stand at any given moment,” The ratio measures the aggregate value of the US stock market relative to the country’s economic output.
Where is it now?
It is currently at its highest level ever.
Investors are paying over $2 for every dollar of US GDP, compared to a long-term average of $0.82. Buffett went on to say, "for me…if the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200%–as it did in 1999 and a part of 2000–you are playing with fire"
I’m not one to argue with Buffett’s thoughts, so this isn’t a great sign.
Indicator Conclusion: Significantly Overvalued
4. S&P 500 Dividend Yield
The dividend yield is the aggregate dividend of all the companies in the S&P 500 divided by the price of the S&P 500. Basically, this is how much the 500 largest US companies are paying investors in terms of dividends.
All else being equal, a low or falling dividend yield means high or rising share prices. Currently the S&P 500 dividend yield is at a 20-year low. Over the last 10-years it has hovered between 1.75% - 2.25%, it’s currently at 1.26%. And there are only two ways for this number to increase, either dividends increase, or stock prices drop. I know which one I’d prefer.
Indicator Conclusion: Overvalued
5. The Yield Curve
Long-term treasury rates are almost always higher than those of shorter-term rates.
Because investors expect to be compensated for lending money over longer periods of time due to risk and the time value of money.
However, when shorter-term rates are higher than longer-term rates - the opposite of what is “normal”, it signals shaky confidence in the economy, and typically leads investors to shift from riskier assets to safer assets, in essence moving from stocks to bonds. This phenomenon, known as an inverted yield curve, has rather consistently foreshadowed recessions and market downturns.
A popular yield curve measure used by the market is the spread between the 10-year treasury vs. the 2-year treasury. Just before the last four recessions, the 10-2 spread went negative and the stock market turned negative shortly thereafter. The good news is currently the yield curve is “normal” with the 10-2 spread sitting right around its historical average.
Indicator Conclusion: Normal
Is a Market Correction Coming?
The short answer is yes.
Because corrections happen somewhat regularly. Since the Financial Crisis there have been 4 corrections of 15% or greater, with 1 of these 4 corrections being the Covid correction of over 30%.
Not only can corrections occur by prices dropping, but corrections can also come from prices staying flat (for years) despite company growth—rising earnings, sales, book value, among others without price increases (think the 1970’s). Either way, the market has always ebbed and flowed over time, oscillating between overvaluation and corrections, but the long-term trend is positive if you have the time.
While I don’t advise dancing in and out of the market based upon headline news. I do think it’s prudent to have some understanding of where we might be in terms of the economic cycle and market valuations.
Why is this prudent?
This gives you a good reason to take some time to thoroughly review what you own, why you own it, and what the future might realistically hold for your portfolio. Having realistic expectations is fundamental to successful investing. With valuations where they are currently, it would be well-advised to use this to temper your future return expectations.
If you have a well-thought out, well-designed portfolio coupled with a rock-solid financial plan then you shouldn’t be overly concerned with market fluctuations.
Although, that’s a big “if.”
-Paul R. Rossi, CFA