Current Market Valuation:   Overvalued

Updated November 27, 2021

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This page is meant as a quck over-view of current market conditions. We focus on a few main valuation techniques and compare them to historical trends. It is important to remember that historical trends may not continue into the future. This is simply meant to be educational and help you make your investment decisions. Using our models we currently believe the market is overvalued.

Valuation Techniques

We look at 4 separate valuation methods and value them based on historical averages. To do that we calculate a base line from their mean (average) over a long time period. We then calculate the standard deviation for them. Anything above a standard deviation of 1 we consider overvalued. Above 2 is very overvalued. Between -1 and 1 is fairly valued. And anything below a standard deviation of -1 is considered undervalued. We then look at all 5 techniques to get a total market valuation.

CAPE Ratio

The CAPE Ratio (Cyclically Adjusted Price to Earnings) is also known as the Shiller P/E Ratio (after Robert Shiller) or the PE 10 ratio. It is the inflation adjusted earnings over a 10 year period. For more information about the P/E ratio, inlcuding the CAPE Ratio, check out our blog post.

The current 10-year P/E Ratio is 38.23. The historical average since 1940 is 18.94. This means it is currently 101.9% higher (or 2.44 standard deviations) above the 80 year average, which suggests the market is currently very overvalued.

Graph of historical/present values of the CAPE Ratio (Shiller P/E). It also includes standard deviations
                to compare to historical average.

Interest Rates

The current 10-year treasury bond is at 1.55%. This is much lower then the average since 1940 of 5.11%, although with inflation raising to higher levels, it wouldn't be surprising to see interest rates go up. This means the 10 year treasury bond is currently 1.22 standard deviations below mean. Let's compare that to the S&P 500 to get a relative valuation.

Graph of 10 year treasury rates over the past 80 years with standard deviations and historic average.

On the other hand, the S&P 500 has had the greatest bull run ever over the last 10 years. We use an exponential trendline to show the compounding returns year over year.

Graph showing inflation adjusted S&P 500 prices with an exponential trendline, as well as comparisons to other
                time periods when there was a large difference between trendline and actual price.

And here is a chart with the S&P 500 detrended from our exponential trendline. This allows us to view and compare the highs and lows better, and makes it easier to view the standard deviations.

A graph showing the S&P 500 detrended from the historical trendline, to better show when it is over/under valued.

As you can see it is currently 1.91 Standard deviations above trend, which would suggest the market is overvalued, but to get the value relative to interest rates, we will subtract the 1.22 standard deviations below normal from the interest rate from the 1.91 standard deviations above normal for the S&P 500. This gives us a relative S&P 500 0.69 standard deviations above average. This suggests that the market is fair valued currently.

Market Cap to GDP (Buffett Indicator)

The 'Buffett Indicator' famously got it's name from when legendary investor Warren Buffett called it 'probably the best single measure of where valuations stand at any given moment'. The Buffett indicator compares the total US market capitalization (using the Wilshire 5000 index) to US GDP. The theory is when market returns are far exceeding GDP growth, eventually market returns will slow.

The Buffett Indicator has seemingly been trending upwards since 1995, which some argue is due to the GDP not capturing all overseas profits from US companies. Kathy Wood (ARK Investing) also recently mentioned in a tweet to Elon Musk that technology and innovation have increased productivity, thus driving down prices and fueling demand.

We really don't know if this is a long term trend or if it will eventually revert back to normal. Our model will continue to get more accurate as it gets more and more data.

For our Buffett Indicator model we have tried to take into account the upward trend by including a slightly exponential trendline. We then detrend the historical Market Cap to GDP ratio to our trendline so we can see how it compares in the present day to historical values.

Graph of historical values of the Market Cap to GDP Ratio (Buffett Indicator). It also includes an exponential trendline
            to take into account the upward trend of the ratio.

Our first chart shows the historic ratio with our exponential trend line. As shown, the current ratio is 219%. Comparing this to our exponential trendline, which suggests a Market Cap to GDP ratio of ~132% would be fairly valued.

Our next chart shows the ratio detrended from our exponential trendline.

Graph showing the historical values of the Market Cap to GDP Ratio (Buffet Indicator) detrended to our exponential trendline.

As shown in the graph, the current Buffett Indicator is 219%, about 87.8% higher than the 131.82% the exponential trendline suggests is fair value. This would suggest the market is very overvalued. In comparison, at the peak of the dot com bubble it was 76% higher (2.73 standard deviations). And at the bottom of the housing crash in 2009, it got as low as -37% (1.33 standard deviations).

For this calculation we use the Wilshire 5000 index, the total GDP, and the estimated current quarter GDP. We multiply the Wilshire index by 1.15 (a single point represents 1.15 billion of index market value), then divide by the GDP. This gives us our Market Cap to GDP.

Yield Curve

Some people believe an inverted yield curve is one of the best indicators of a upcoming recession. History would tend to agree with them. An inverted yield curve has preceded the last 7 recessions

Before the 2008 crash, yields were inverted starting in 2006. Again in 1998 and April of 2000, before the dotcom crash, the yield curve inverted. Most recently, in 2020, the yield curve again inverted on Febuary 25th, just before the market crashed in March. The Federal reserve then walked back interest rate increases.

Here is a chart showing the historic treasury yield spread between the 10 year and 3 month yield. When the spread is negative, the yield curve is inverted.

Chart showing the historical spread between 10 year treasury yield and 3 month treasury yield. When the yield is negative the yield curve is inverted  (currently 1.42% spread).

And here is a chart showing the current yield curve, as of November 27th, 2021.

Photo of the current yield curve as of November 27th, 2021, which is not inverted.

The current yield curve is not inverted. As shown, treasuries with a longer maturity have a higher return, as would be expected under normal circumstances. There is currently a 1.42% spread between the 3 month yield and the 10 year yield.

Data Sources

Source Description Historical prices of Whilshire 5000 Index for the Market Cap to GDP Ratio. Historic GDP data for the Market Cap to GDP Ratio. Estimate of the current quarter GDP for the Market Cap to GDP Ratio. Robert Shiller, Cape Ratio, S&P Historic Prices, 10 Year Treasury Yields.