I often get asked by my clients: "Is the stock market currently overvalued?" This is a valid question, especially after the strong rally we have seen in the past year. In this blog post, I will try to answer this question by looking at some of the most widely used indicators of market valuation: the Buffett Index, the Yield Curve, and the Schiller PE Ratio. Then I will provide you tips on what you should do next.
The Buffett Index is the ratio of the total US stock market value to the gross domestic product (GDP). It is named after Warren Buffett, who once said that this ratio is "the best single measure of where valuations stand at any given moment". The higher the ratio, the more overvalued the market is relative to the size of the economy. As of January 11, 2024, the Buffett Index was 175%, which is higher than 98% of its historical readings and suggests that the market is strongly overvalued.
The Yield Curve is the difference between the interest rates of long-term and short-term Treasury bonds. It reflects the expectations of investors about future economic growth and inflation. A normal yield curve is upward sloping, meaning that long-term bonds have higher yields than short-term bonds. This indicates that investors expect higher growth and inflation in the future. A flat or inverted yield curve, on the other hand, means that long-term bonds have lower or equal yields than short-term bonds. This indicates that investors expect lower growth and inflation in the future, or even a recession. A flat or inverted yield curve has historically been a reliable predictor of economic downturns. As of January 11, 2024, the yield curve was inverted, with a 10-year Treasury yield of 3.95% and a 2-year Treasury yield of 4.16%. This suggests that investors are not very optimistic about the future economic prospects.
The Schiller PE Ratio is the ratio of the price of the S&P 500 index to its average inflation-adjusted earnings over the past 10 years. It is also known as the cyclically adjusted PE ratio (CAPE) or the P/E10. It was invented by Nobel laureate Robert Shiller to smooth out the fluctuations in earnings caused by business cycles. The higher the ratio, the more overvalued the market is relative to its long-term earnings potential. The Schiller PE Ratio has historically been a good indicator of future stock returns over long horizons. As of January 11, 2024, the Schiller PE Ratio was 32.7, which is 24.2% higher that the recent 20-year average. This implies that the market is extremely overvalued and that future returns will be below long-term averages.
Based on these three indicators, it seems clear that the stock market is currently overvalued by historical standards. However, this does not mean that a crash is imminent or inevitable. There are many factors that can influence market movements in the short term, such as interest rates, earnings growth, investor sentiment, geopolitical events, etc. Moreover, valuation metrics are not perfect and may not capture all aspects of market dynamics. For example, some argue that today's interest rates justify higher valuations, or that today's market is dominated by high-quality technology companies with above-average profitability.
In Merrill Lynch's 2024 Market Outlook Marci McGregor, the head of Portfolio Strategy, Chief Investment Office, Merrill and Bank of America Private Bank, stated that “Currently there are really only about 10 stocks that are expensive. The rest of the market is pretty fairly valued.”
Therefore, as an investor, you should not rely solely on valuation indicators to make your investment decisions. Instead, you should focus on your long-term goals, risk tolerance, and time horizon. Make sure that you have a plan and that you stick to it, and of course NEVER panic sell. Here are some suggestions on what you can do to navigate the current market environment:
- Consider further diversifying your portfolio by adding alternative investments such as real estate, commodities, private equity, hedge funds, etc. These assets can provide different sources of return and reduce your exposure to stock market fluctuations.
- Consider value stocks over growth stocks. Value stocks are those that trade at low prices relative to their earnings, book value, dividends, etc. Growth stocks are those that have high expectations of future earnings growth. Historically, value stocks have outperformed growth stocks over long periods of time, especially after periods of high market valuations. Value stocks may also offer higher dividends and lower volatility than growth stocks.
- Create a plan for if and when the market takes a downturn. This means having a clear idea of how much loss you can tolerate and how you will react if it happens. You should also have some cash reserves or liquid assets that you can use to cover your expenses or take advantage of buying opportunities in case of a market correction.
- Consult a professional financial planner who can help you design a customized portfolio that suits your needs and preferences.
I hope this blog post has given you some insights into the current state of the stock market and some ideas on how to deal with it. Remember, the market is unpredictable and volatile in the short term, but it tends to reward long-term investors who are disciplined, diversified, and patient. If you have any questions or comments, please feel free to contact me.
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