What Does “Overvalued” Mean?

Executive Summary

What does stock market overvaluation mean? Overvaluation refers to whether the price paid for a stock is higher than what would be considered reasonable based upon corporate revenue and earnings. One benchmark is the price-to-earnings ratio (P/E), which has a long-term median of 15. The current P/E based upon 12-month trailing earnings is 30.7 or double the long-term median. Another marker is the CAPE ratio, which uses 10-year average, inflation adjusted earnings to smooth the swings in the business cycle. Its long-term median is 16 and currently it is around 38.5. And finally, the Buffett indicator, which is Warren Buffett’s favorite valuation indicator, sits two standard deviations above the long-term historical trend (first graph). Recent articles have noted Buffet has trimmed some of his largest holdings and is now sitting on $325 billion in cash (second graph). Bubbles can continue to grow, meaning prices get more overvalued; however, with them grows the risk of a major correction.

Please proceed to read The Details below for more information.

“A generation which ignores history has no past and no future.”
–Robert Heinlein

The Details

I frequently write about the current state of stock market overvaluation. But what does that actually mean? And how long will it last? Overvaluation refers to whether the price paid for a stock, or an index of stocks such as the S&P 500, is higher than what would be considered reasonable based upon corporate revenue and earnings. Stock prices effectively represent the present value of a long-term stream of income. In other words, what would one pay today in order to receive a certain stream of income in the future? History shows, according to Multpl.com, that over the very long term, the median price of the S&P 500 Index has been about 15 times earnings for the companies included in the Index. The current price-to-earnings (P/E) ratio, using 12-month trailing earnings, is 30.7, over double the long-term median.

Using data from Multpl.com, one can look at a derivation of the P/E ratio, called the Shiller P/E or CAPE. The name Shiller P/E is used because Professor Robert Shiller, building on the works of Benjamin Graham and David Dodd, developed a P/E ratio using 10-year average, inflation-adjusted earnings instead of using just the prior 12-month’s earnings. The reason for this is to provide a more consistent ratio by eliminating the wild swings during the business cycle. This ratio has also been called the CAPE or Cyclically Adjusted P/E, and the PE10 – due to the fact that 10-year’s earnings are used in the calculation.

The long-term median Shiller P/E is about 16 according to Multpl.com, and the current ratio is almost 38.5. The only time this ratio has been higher is at the peak of the Technology Bubble in 2000. The current ratio is 2.4 times the median. What does that mean? It means that investors, or speculators, are paying over double the price that long-term corporate earnings would indicate is reasonable. These stretched market cycles have occurred numerous times in the past. And it is important to note that Every time when valuations were this stretched, a major correction occurred at the end of the cycle. The corrections were often in proportion to the degree of overvaluation priced into the market. For instance, after the peak in 1929, the market fell over 86%. After the Technology Bubble, which peaked in 2000, the S&P 500 fell close to 50% while the technology-heavy Nasdaq 100 Index fell around 83%. During the Great Recession and Financial Crisis, 2007-2009, the S&P 500 again fell around 50%.

These plunges in stock prices brought prices back in line with corporate earnings. Often, when a strong bear market cycle occurs after a prolonged bull market, stock prices fall to levels considered undervalued. To reach undervalued prices, stocks would have to fall at least 65-70%.

Many investors do not believe this will happen. At the top of bubbles, optimism also tends to surge. This optimism is what pushes valuations to their extremes. Those who have lived and invested through prior stock market cycles often become wise to the ultimate outcome. One widely known individual is Warren Buffett. He is known as a market expert with much experience. In fact, a stock valuation indicator that he suggested is his favored valuation methodology, Market Cap-to-GDP, has been named the Buffett Indicator.

The Buffett Indicator, shown in the graph below prepared by www.currentmarketvaluation.com, shows the current price of the market is over two standard deviations above the long-term historical trend. Two standard deviations is a statistical measure that means, historically, this level of over-pricing occurs less than 5% of the time.

It is for this reason that Warren Buffett himself has taken notice. In a recent Financial Times article, it was noted, “Buffett has raised Berkshire’s cash levels to unprecedented heights. At $325bn, cash now accounts for 28% of Berkshire’s asset value — the highest level since at least 1990.” The following graph is from the Financial Times.

It appears that Warren Buffett is so concerned about the price level of the stock market that he has increased his cash position to the highest level in over three decades. There are two reasons he would do such a thing: 1) he feels that prices are too high to deploy cash and/or 2) he wants to build up cash reserves so after the next market correction he will have cash available to buy investments at more reasonable prices.

“Overvalued” means prices of stocks are too high compared corporate earnings, based upon over a century of historical data. Can this bubble continue to grow? The answer is, absolutely. But the important point to note is that when the next serious bear market occurs, history has proven a drop in prices of over 60% would not be considered unreasonable. Even the most experienced investors see it. Do you?

The S&P 500 Index closed at 5,996, up 4.7% for the week. The yield on the 10-year Treasury Note fell to 4.31%. Oil prices decreased to $68 per barrel, and the national average price of gasoline according to AAA fell to $3.09 per gallon.