Based on commonly used valuation metrics for the S&P 500 US Stock market index, the U.S. stock market is currently overvalued between (approximately) 56.94% and 98.06%. These are levels last seen prior to the Technology crash of 2000-2002 and just prior to the financial crisis of 2007.
As a professional portfolio manager, I love long term investing in the US stock market. I believe investing in stocks has proven historically to be the more effective way to grow your portfolio over the very long term. But even on the low end of the current valuation scale for U.S. stock values… investors should be very aware of their risk tolerance and amount of stocks held in their portfolio… along with expectations of continued stock market growth vs. potential for economic downturn.
I will once again support my clients with the growth prospects of US stocks…but at these levels it may be time to discuss more defensive strategies. I am not a “perma-bear” (an investor or adviser who is always thinking that the stock market will meet its demise at any moment). But there are times as history has shown that at the end of economic super cycles, investors should be highly cautious and know their investment options to help preserve their portfolios.
The Price to Earnings Ratio (PE Ratio):
One of the common measurements for determining how fairly valued a stock’s price is at a given point in time is the “PE” ratio, or Price to Earnings ratio. The PE ratio is a formula which entails a company’s stock price relative to its earnings per share. The average Price to Earnings ratio (PE ratio) for a correctly valued stock price is approximately 161. This means that a company’s “fair” value is equal to approximately 16 times its annual earnings per share.
The PE ratio can give investors information as to whether a company’s stock price is undervalued, about at correct value, or overvalued. Below is a current assessment using two of the most widely accepted types of PE ratios to give a snapshot in time of the current value state of the S&P 500 index of stocks:
12 month trailing earnings Price to Earnings Ratio: (uses past 12 months of actual reported earnings)1
As of 02/06/2020: 12 month trailing PE is 25.11
- A PE of 25.11 means the S&P 500 Stock market index is approximately 56.94% overvalued
Shiller Price to Earnings PE Ratio: (uses inflation adjusted reported earnings over last 10 years)2
As of 01/17/2020: Shiller PE ratio is 31.69
- Based on the Shiller PE of 31.69, the S&P Stock market index is approximately 98.06% overvalued.
Based on these two widely used metrics of stock market valuation, the S&P 500 index is currently overvalued between 56.94% and 98.06.%. I feel these very high levels should raise red flags to those who own stocks, and are valuations not seen last since the peak of the Technology Boom of the late 1990’s, and the Housing Boom of about 2006. Evidence is clear on how Technology Boom and Housing Boom ended.
When stock prices reach valuations at these levels, it generally is an indication that the profitability of the average company on the S&P 500 is much lower than its stock price is showing. This means that either the earnings per share of a company will need to increase substantially, or the price of the stock needs to come down substantially.
Stock Markets Are Not Always Rational:
We find ourselves in a state of what past-Federal Reserve Chairman Alan Greenspan coined in the late 1990’s called “irrational exuberance”. This phrase conveys a sentiment where prices of stocks and other assets are elevated to such high levels regardless of the fact that underlying economic fundamentals (earnings) are not growing enough, or are going in the opposite direction. An overvalued state in the stock markets can go on for some time. But ultimately history has shown us that markets have corrected down (at times substantially) to levels more in line with company earnings and other economic fundamentals.
US Federal Reserve possibly fueling buying of stocks:
Since October of 2019, the Federal Reserve Bank has been adding very large amounts of liquidity (cash) to the financial system. As of today this number has surpassed $600 Billion and counting. (https://fred.stlouisfed.org/series/WREPO) When the Federal Reserve does such operations, it is doing so in an "emergency" capacity due to some sort of financial system problem. This time around, the problem is in the corporate financing markets, or the REPO markets. (please see link below for further details.3
A by-product of all this money coming into the financial system is higher stock prices due to funds becoming available to non-traditional borrowers. These Federal Reserve funds have been used to purchase stocks, pushing up values substantially. Other than the Federal Reserve injecting very large amounts of cash into the financial system, there is little fundamental justification for stock prices to be continuing their very high ascent. If and when the Federal reserve were to stop providing the excess cash to the system, the stock market would more than likely decline, possibly substantially. The Fed ran very similar cash injecting operation in the late 1990's, which they ended in March of 2000. At that point, stock market sold off dramatically... for more than 2 years.
4 U.S. economic growth estimates from today released by the Federal Reserve show that the economy continues to slow. Current estimates are showing Gross Domestic Product for the 1st quarter 2020 at an estimated growth rate of about 1.6%. (www.newyorkfed.org/research/policy/nowcast) simple terms, if the GDP number (growth of US business activity) turns negative, the US economy will be in a state of contracted economic growth which then has a higher probability of leading to a recession.
Know history and your investing options:
5Due to the overvalued state of the overall U.S. stock market, along with declining economic growth…. stock market investment risk may be considered much higher than average today. https://www.cnbc.com/2020/01/14/the-stock-market-has-never-been-this-big-relative-to-the-economy-signaling-it-could-be-overvalued.html. 6 During each of the two last recessions (2001 and 2007-09) where stocks and real estate assets were considered highly overvalued, the S&P 500 dropped approximately 55%. The average recovery time needed to gain back pre-crash value of losses from the Technology Bust was 8 years and the average recovery time for recovery from the Great Recession for stock was 7 years.
I highly suggest anyone who owns a stock portfolio of any size to evaluate their time horizon for their investments and understand their risk exposure. In addition, take a look at historical stock market performance of the last two Recession periods.
Periods of “irrational exuberance” and highly overvalued stock markets may continue for some time, but the current highly overvalued state we find ourselves has been going on for approximately 2 years now. Given these facts, one has to ask themselves the following questions…. Are we slow walking towards a recession? If so, what can I do to preserve my investments?
We at Bacci Investments Group, Inc. have been employing defensive strategies which may help preserve against stock market and recessionary type risk.
Contact us today for a no cost, no obligation consultation.
Michael R. Bacci, CFP
LINKS TO INFORMATION SOURCES:
1) Trailing 12 month PE Ratio: S&P 500 company earnings as reported last 12 months Price to Earnings Ratio.
2) Shiller Price To Earning Ratio:
3) Federal Reserve of New York "Nowcast" estimated measurement of United Stated Gross Domestic Product for 4th quarter 2019.
4) "The Federal Reserve is the cause of the bubble in everything": https://www.ft.com/content/bc83fda6-3702-11ea-a6d3-9a26f8c3cba4
5) “The stock market has never been this big relative to the economy, signaling it could be overvalued”
PUBLISHED TUE, JAN 14 202012:59 PM ESTUPDATED TUE, JAN 14 20207:06 PM EST
6) 11 historical bear markets: From Great Depression to Great Recession.
History and past performance are not a guarantee of future performance. Information contained in this commentary is not the opinion of Royal Alliance Associates, Inc. or it’s affiliated companies. Any information contained within this commentary is not a solicitation to buy or sell securities or advice to buy or sell securities.