One of the more difficult issues facing today’s investor is the apparent overvaluation of the U.S. stock market. Several years ago, Benjamin Graham suggested that, as the price of a security increases, the prospect of a future profit decreases.

If we apply his logic to today’s U.S. stock market, one would conclude that future stock returns may be well below average. Despite the demonstrated resiliency of the present bull market, there will most certainly be a correction at some point. Moreover, the longer this bull persists, the severity of a decline rises as well. In this blog, we’ll take a closer look at this issue.

Market Valuation

As of Friday, Dec. 8, 2017, the current bull market was 3,196 days old (total days). This ranks as the second-longest bull on record. How overvalued is the domestic stock market?

Fortunately, we have several methods to help answer the question.

Perhaps the most widely accepted compares total U.S. stock market capitalization to GDP. The premise behind this option is that rising stock prices need the support of economic growth. This option was also dubbed “Warren Buffet’s favorite” market valuation tool in a Fortune magazine interview from December 2001. Using this option, U.S. stocks are currently 40.3% overvalued. Since January 1971, stocks have only been more overvalued on 26 days, or 0.27% of the total period. It’s worth noting that the peak was when the dot-com bubble burst in March of 2000.

Another stock valuation metric is Tobin’s-Q Ratio, which divides the market value of all U.S. stocks by their aggregate book value. A ratio of 1.00 indicates stocks are fairly valued. Currently, the ratio is 1.086, compared to its all-time high of 1.775, also during the dot-com bubble. According to this measure, stocks are over-valued, but not significantly.

Finally, we will consider the cyclically adjusted price-to-earnings ratio (a.k.a. CAPE, Shiller P/E, or P/E 10 ratio), developed by 2013 Nobel Laureate Robert Shiller. Shiller uses an average of the P/E ratio over the trailing 10 years, after adjusting for inflation. The average CAPE ratio since January 1900, is 16.79. The current reading is 31.30. The all-time high for this ratio is 44.20 (December 1999), also just before the demise of the dot-com bubble. Therefore, according to Shiller’s ratio, stocks are over-valued, but not as much as during the dot-com bubble.

Is a correction looming? Are stocks over-valued, and if so, by how much? Here is a summary of the three valuation methods cited.

Ratio

Indication

U.S. Stock Market Cap to GDP

Extremely Over-Valued

Tobin’s-Q

Slightly Over-Valued

Shiller’s CAPE ratio

Moderate to Extremely Over-Valued

If the U.S. economy begins to improve, the first ratio will relax a bit. However, many experts believe the U.S. economy will weaken, which is supported by the flattening yield curve. It’s entirely possible that the U.S. will enter a recession, which, as history has demonstrated, is accompanied by a decline in stock prices. This may well be the catalyst for the next correction. Stay tuned.

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