How Overvalued Are Stocks? 3 Key Ratios Give the Answer(s)

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.

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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