The stock market is going to crash! Pull out all your money before it's too late! People have been saying this for the last 4-5 years now. Imagine the gains you would have missed out on if you were sitting on the sidelines for the last 5 years, un-invested?! No one can correctly guess when or if the market is going to crash. In this blog post we take a closer look at whether the stock market is currently over-valued, and whether there is anything you can do to prepare yourself.
Let’s start out by looking at the historic P/E (Price to Earnings) ratio of the S&P 500. This will give us a good idea of what companies are currently selling for relative to earnings, and how it compares to the past.
As shown in the chart above, the current P/E ratio is at 40. As far as P/E ratios go, that is considerably higher than the historic S&P 500 average. Does this mean the market is over-valued? Not necessarily. It could mean that investors are overly optimistic about companies’ future earnings and are therefore willing to pay a premium in the present for them. What it does mean is that the market is pricing in an expectation for earnings growth, and if that growth doesn’t materialize, prices will likely drop.
Shiller P/E Ratio
Now let’s look at another chart. The Shiller PE Ratio, also known as the P/E 10 Ratio. The Shiller ratio uses average inflation adjusted earnings from the previous 10 years.
From looking at the chart, you can see the current Shiller Ratio is quite high compared to the average. One of the shortfalls of looking at these charts is that you can never tell how high it’s going to go before it drops. Though it does allow you to see the general trends the market has followed in the past, and seeing where we are today.
Looking at the tech bubble in the late 1990s and early 2000s, the Shiller PE Ratio peaked around 44 in December 1999, and the market started to crash in September 2000. The market didn’t start to recover until early 2003, nearly 3 years later, at which point the Shiller P/E was around 21.
Compare that to the crash of 2008, the Shiller PE had only recovered to 27 before the market crashed again. This shows that only looking at the Shiller P/E ratio is not enough and does not give a full picture.
The current Shiller PE ratio is around 35.
One of the most over-looked metrics when considering over-all market valuation is interest rates. Higher interest rates tend to hurt the stock market. Often used as the risk-free rate for discounted cash flow calculations, 10-year treasury bonds are probably the most secure way to invest your money.
Here is a chart of historic 10 year treasury bond rates.
Interest rates have slowly been on the rise since summer of 2020. That being said, they are still very low compared to historic rates. Generally, when rates are low, stock prices go up. There are multiple reasons for this. One is when rates are low, investors are forced to look at riskier investments (such as the stock market), more money in the stock market means higher prices. That is more true then ever over the last few years, as bonds have not even outpaced inflation. Another reason is that companies can borrow money at a much lower interest rate, therefore expanding their operations and hopefully increasing revenue.
On the other side of the spectrum, when rates start to rise again, investors might get worried of the effect it will have on the market. This may cause them to pull out and re-invest into bonds.
No one knows really knows what interest rates will do. It is out of the investors control. It is a good idea to note where we are in the grand scheme of things, and realize that there isn’t much place for interest rates to go from here, except up. One thing to mention is that interest rates alone are unlikely to rise fast enough to cause the market to crash like in 2000 or 2008. Even if they do trend up over the next few years, it is likely going to happen in small increments.
Market Cap to GDP Ratio
Also known as the Buffett Indicator, after legendary value investor Warren Buffett. He once said, “it’s probably the best single measure of where valuations stand at any given moment”. It is calculated by dividing the stock market cap by gross domestic product (GDP).
Let’s look at a chart of the historical Market Cap to GDP Ratio, using the Wilshire 5000 Total Market Index.
As shown in the chart, at the time of this writing, the Market Cap to GDP ratio sat at an all-time high of 216%. This would indicate that by this measure the market is considered very over-valued.
We’ve gone over 4 of the main metrics used to determine if the market is over-valued. So.. is it over-valued? It’s hard to say.
When trying to determine how the market is valued you can’t just look at one variable. If you only looked at the Buffett Indicator, you would think it’s extremely over-valued, but if you only looked at interest rates, you might think the opposite. It’s important to take all metrics into account and come up with your own opinion.
To me, the market is currently over-valued. Does that mean I’m sitting on the sidelines with boat loads of cash waiting for a crash? No. No one can correctly time the market. Even when the market is over-valued, there are still deals to be found. They are just much harder to find.
"Time in the market beats timing the market."
Do you think the market is over-valued? How has that effected your investment approach? Let us know in the comments!
- www.Quandl.com - S&P 500 P/E Ratio by month, Shiller P/E Ratio
- www.Treasury.gov/ - Historic 10 year treasury yields
- www.frbatlanta.org - Current GDP Predictions
- fred.stlouisfed.org - Historic GDP, Historic Willshire 5000