How To Tell When The Stock Market Is Overvalued

Speaker 1: One of the most asked questions that investors are curious about is how do you tell whether the stock market is overvalued? Are prices too high? Should we wait for the market to go down or is now actually a fine time to get in? And this is an important question to ask, because let’s be honest, no one likes putting their money in the stock market and then seeing prices fall. It’s not a fun experience.

I’ve certainly gone through it before and it wasn’t fun. But there are a number of indicators that we can look at in order to determine if the market is overvalued or at the very least get a good feel for where market valuations stand. In this video, we’re going to explain the four key indicators that we can use to determine whether a market is overvalued, fair, valued or under priced. I’m going to use the current USA market as an example, but you can use any market at any time with these four indicators.

Now, I’m sure you’ve heard of this metric before, the P e ratio or the price to earnings ratio. I don’t know if you’re aware of this, but you can actually get the P e ratio of the entire market as a whole and you can use this to get a feel for if things are overvalued. Let me explain. So the market PE ratio, what you first need is a gauge of the entire market. Now, in the USA, they have an index called the S&P 500. The S&P 500 measures the performance of 500 very large and popular companies in the States. Essentially, this index attracts the entire USA market. It’s known as a benchmark for the market as a whole. So what we do is get the price of the index, a.k.a. how much do stocks overall cost? And then you compare this to the earnings, a.k.a., how much money are the stocks bringing in in terms of profit? Of course. So cost versus profit, it’s the oldest benchmark figure in the book. And this PE is simple to find. All we do is do a good old Google search and we go on the website, multiple NORCOM, which shows us this graph. Now, as you can see, the current S&P 500 PE ratio is thirty two point nine five. If you take that and look through history, you can see that it’s quite a bit higher than its normal figure. The average PE ratio throughout history is fifteen point eighty five. Right now it’s double that, which isn’t a good sign. I mean, the PE ratio is similar to what it was back in 1999 where the dotcom crash was just about to happen and 1999, the market PE was thirty two point nine, similar to today. This potentially means the current market may be overvalued, but we have to look at the other indicators in order to confirm this hypothesis. Now, there’s been investors have come along and they’ve criticized the traditional PE ratio for measuring the markets.

They say earnings in a particular year can fluctuate because of business cycles and thus it’s not accurate. That’s where Professor Robert Shiller came along and he developed something called the Shiller p e ratio. What he did was he averaged the earnings over the past 10 years and he adjust them for inflation so that market fluctuations would not be in the equation. Thus, a lot of investors believe it’s a more accurate way of measuring the market anyway. So currently the Shiller P e ratio sits at thirteen point two seven. That’s a lot higher than what it normally is. If you look back through history, the average Shiller p e ratio throughout history, the past hundred years or so is sixteen point seven five. So it’s about 14 points higher than the average at the current point in time of making this video.

However, the average over the past 20 years is twenty five point six, which would make things seem a whole lot more reasonable. And by the way, yes, I’ll leave a link in the description if you want to check out these graphs that I’ve shown you. But there’s more to the story than what I’ve shown you. There’s more indicators we need to look at to confidently tell whether the market is overvalued or not. Warren Buffett, OK, he’s known as the greatest investor of all time. He’s also known as someone who doesn’t like to time the market. He just focuses on buying good quality companies on sale. However, he does use one formula to see how the market is looking. He said in a Fortune magazine interview that it is probably the best single measure of where valuation stand at any given moment. What the Buffett measure is, is that the market cap of corporate equities divided by nation’s GDP, essentially it’s the total prices of stocks compared to how much they’re producing in terms of goods, gross domestic product. So at the current point in time, the Buffett Indicator sits at one hundred seventy one point seven.

Now, that’s high. It’s higher than what it was in the 2008 housing bubble crash, and it’s even higher than what it was in the dot com market crash. I mean, as Buffett said, the indicator spiking before the dot com crash should have been a very strong warning signal. And perhaps it should be the same thing today, because what it’s saying is corporate equities, you look at the prices and they’re very high. Then what you do as you compare it to how much these equities are producing GDP, a.k.a. how’s the economy going? And it’s not going great. So there’s a big distinction between prices of stocks and the economy. And this is why you see such a high figure with the Buffett indicator. Now, this, for me, is the ultimate way of determining whether the market is overvalued or not, because what you’re doing is relating the returns that you can get in the markets versus the returns that you can get in other asset classes at the end of the day when something is overvalued. It’s all relative. And you need to be comparing this to something. And this is what this method does. Let me explain. The very first thing that we need to determine is what the return that we can get in the market currently. And a lot of beginner investors mostly will say you can’t find that out.

Well, you actually can with a simple calculation. So do you remember we calculated the market PE earlier on. We’re going to need that figure again. So the market Papageorgiou memory, it’s thirty two point nine five price divided by earnings equals thirty two point nine five. For this calculation, we need the inverse of that. OK, earnings divided by the price. So if we divide one by thirty two point nine five, we can see that earnings is three point three percent of the price. So if you pay a hundred dollars for a stock in the market, you’ll get three dollars and three cents back on average, a.k.a. a three point zero three percent return. So the market return is three point zero three percent. However, the one thing that we’re missing is the growth and the equation, the growth of these earnings, because earnings will grow as time goes along. Everyone knows that to calculate growth. That’s very simple as well. We just see what growth has been over the past couple of years and we extrapolate that to the future. So what we do is we type in USA GDP growth on Google and we can see that it grows somewhere in between two to three percent. At least that’s what it’s done over the past five or so years. So we can assume that in the future it will be doing something similar. So what we need to do is add two point five per cent of growth to our original three point zero three percent figure and we get a five point five three percent return. Meaning if we buy stocks in the U.S. market, we can expect a five point five three percent average long term return.

Normally, the market will give you a 10 percent return on average at least. That’s been the average annualized return since the 20s 1920s. However, because stocks are at very high prices, that return has gone dramatically lower. As I’m sure you know, the higher amount you pay for something, the lower the expected return is. That’s just basic accounting, basic business. So the stock market return and the USA is 5.5 percent around that anyway. However, what about other asset classes? Because, as I said, it’s all relative. We have to have our money somewhere. Right. And some form of assets and cash or whatever it may be. Now, the main asset that investors compare things to is bonds. These are the two main forms of passive income assets that investors focus on, bonds and stocks. Of course, you got real estate as well, but that’s less passive and not everyone wants to do that. So as normally bonds money and the bank vs. the stock market, luckily, the return for bonds is a lot easier to get. All we need to do is go on the CNBC website straight to the 10 year Treasury bond. As you can see right now, it’s setting at zero point eighty six per cent, very, very low. Doesn’t matter what you compare it to, if we look back through history, it’s basically at the bottom. And if you look at the two year Treasury, it’s a lot worse. It’s at zero point one six percent, essentially. That’s just nothing. So if you have your money in bonds, you’re getting a very low return. And it’s the same with a bank banks at the most. You’re going to get a one per cent return each year. And the reason for this is because of the Fed. Of course, they control interest rates and they have set interest rates to essentially as low as it can possibly go before it reaches negative. So if we look at this from an investor’s point of view, you analyze all of the indicators and what they point to is the market being overvalued. You do the calculation and you can realistically only expect a five point five per cent return at current prices compared to the 10 per cent return in what you normally would get. Then you go and look at the other main option where you can put your money and that’s the bank and bonds. And if you put your money there, you actually lose money because inflation is normally two per cent, which is greater than the one per cent ish return in banks and bonds. And this is why you’ve got investors still investing in the stock markets even. Even though prices and indicators are showing us that it is very high, there’s nothing else to do with your money. Bonds give you nothing.

The bank gives you nothing. So the main factor that will change things is if the interest rates go up. And that’s the one factor that we really need to keep our eye on anyway. What I’ve just showed you as a tried and true methods used by investors throughout time in order to get a gauge of the markets. And I thought it useful to share with you guys today. Invest wisely, everyone.

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