Are stocks over-valued? Is it time for caution? In this post we will discuss the efficacy of two commonly used stock valuation ratios. In other words, can they be trusted to predict a market top? First, here’s an overview of the current level of domestic stocks.
Based on daily closing values through November 6, 2019, the S&P 500 Index reached an all-time high this past Monday, November 4. The Dow and Nasdaq Composite peaked a day later. These bellwether indexes are doing well with the help of strong economic data and a renewed optimism on trade. Are stocks over-valued?
Stock Market Valuation
Stock valuation ratios are designed to help determine the extent of the over- or undervaluation of U.S. stocks, in the aggregate. We will look at the Shiller CAPE Ratio and the stock-market-cap-to-GDP-ratio (SMC-GDP).
Shiller CAPE Ratio
The Shiller CAPE Ratio goes back the farthest, dating to the late 1800s. For more on this ratio, click here. Here are some past readings when the market was at, or near a top.
- September 1929: The CAPE ratio rose to 32.56. The Dow peaked the same month.
- December 1999: The CAPE hit an all-time high of 44.2. The Dow peaked at 11,722.98 the following month, January 14, 2000.
- January 2018: The CAPE reached 33.1. The Dow reached a record high of 26,616.71 on Jan. 26.
Currently, the CAPE stands at 28.95, well above its long-term average of 16.98.
Stock-Market-Cap-to-GDP Ratio (SMC-GDP)
According to a quote from Warren Buffett in Fortune magazine in the early 2000s, this was his favorite valuation ratio, at least at that time. For more on this ratio, click here. Let’s examine some past readings.
- March 24, 2000: The ratio peaked at 149.0, setting a new all-time high. The Dow peaked about two months earlier on Jan. 14.
- January 26, 2018: The ratio surpassed its previous high, reaching 149.4. The Dow peaked the same day.
Currently, the SMC-GDP ratio is at 145.6% (100% is fair value). The long-term average is 80.88%.
Both ratios consistently indicated that stocks were over-valued. The CAPE peaked a month earlier than stocks during the tech bubble, while the SMC-GDP topped two months after stocks had peaked. More recently, both ratios peaked the same time as stocks in early 2018. It is my opinion that these ratios are very useful in determining if stocks are over- or -undervalued. However, since stocks can remain over- or undervalued for an extended period, and given the inherent weaknesses of each, they should be used only as a general guide to investment decisions and not to determine trading strategy on a more frequent basis. I think “caution” is the word today, but then again, this overvaluation could persist for a while.
Perhaps this will lend a little more perspective on the current level of stocks. As Benjamin Graham, father of value investing and mentor to Warren Buffett wrote, we should buy stocks after a decline and not after a significant rise. He called this an investor’s “margin of safety.” It is because of these factors (and others), that I remain cautious.