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How to Tell if the Stock Market is Overvalued

Fajasy
Updated: June 26, 2021
Reading Time: 13 minutes

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In this article, I will discuss how investors can use various ratios, yields, indicators, and an understanding of the current state of the market to recognize if the stock market is overvalued, fairly-valued, or undervalued. In short, this process involves looking at the S&P 500 P/E Ratio, the Shiller P/E Ratio, the Buffett Indicator, the S&P 500 Dividend Yield, the S&P 500 Mean Inversion, along with interest rates and the yield curve. By the end of this article, you should know how to tell if the stock market is overvalued or not, regardless of the time period.

S&P 500 P/E Ratio

The price-to-earnings (P/E) ratio is a way to value a company (or fund) by comparing the price of its stock to its earnings. It's a measure of how much investors are willing to pay for each dollar of earnings (aka EPS). In other words, it's a measure of the number of years required to cover the price of a stock, if earnings remain unchanged.

Put simply, a high/low P/E ratio indicates that the current stock price is too high/low relative to earnings, which could be a sign of an overvalued/undervalued stock price. However, high or low P/E ratios aren't inherently good or bad, it's all relative to other similar companies or funds.

P/E ratios can also be applied to indices, such as the S&P 500 Index, to provide investors with an idea on whether the stock market is overvalued, fairly-valued, or undervalued. The S&P 500 Index is used, as it's widely regarded as a benchmark for the entire U.S. stock market.

The P/E ratio calculation is shown below:

P/E ratio = Share price / Earnings per share (EPS)

where:

  • EPS = (Net income / Outstanding shares)

In this case, the stock price would be the current market price of the S&P 500, and the EPS would be the EPS for all 500 companies within the S&P 500. Fortunately, you do not have to calculate this yourself. You can simply go on multpl.com to view a live graph of the S&P 500 P/E Ratio (from 1871 to now).

However, if we reduce this time frame to only be from 1970 - 2021, we can get a better picture on whether the stock market is overvalued or not, as shown below:

For reference, below are the historical averages for the S&P 500 P/E Ratio (data from multpl):

  • Average (1870 - 2021): 15.89
  • 50-Year Average (1970 - 2021): 19.74
  • 25-Year Average (1996 - 2021): 25.82

As of 02/26/2021, the S&P 500 P/E ratio is hovering around 39, which is relatively high. This means that investors are paying $39, on average, for every $1 in earnings that this group of 500 companies earns. Although it has been at these levels in the past, we can see that both times when it was above 39, a recession followed (the Dotcom Recession and the Great Recession). Clearly, according to this indicator, investors will have to work a lot more to find undervalued buying opportunities, at least within the S&P 500.

S&P 500 Earnings Yield

The S&P 500 earnings yield shows the percentage of the index's earnings per share (EPS). The lower this ratio, the more overvalued the index.

The earnings yield calculation is shown below:

Earnings yield = Earnings per share (EPS) / Share price

where:

  • EPS = (Net income / Outstanding shares)

As you can see, this is just the inverse/reciprocal of the S&P P/E ratio, which we already know to be 38.8. 2.58% (1 / 38.8) is therefore the earnings yield for the S&P 500. This means that if you invest $100 in the S&P 500, you'll get $2.58 in return on average annually (which is a 2.58% return).

Again, an up-to-date chart can be found on multpl, while a static chart is provided below:

For reference, below are the historical averages for the S&P 500 Earnings Yield (data from multpl):

  • Average (1870 - 2021): 7.31%
  • 50-Year Average (1970 - 2021): 6.33%
  • 25-Year Average (1996 - 2021): 4.46%

These lower earnings yield figures can be something to keep in mind. However, because this yield is so low, and has only been lower in the last two great recessions, it's fair to say that the market is overvalued.

Shiller P/E Ratio (aka CAPE Ratio or P/E 10 Ratio)

The Shiller P/E Ratio (aka CAPE Ratio or P/E 10 Ratio) averages earnings of the S&P 500 over the past 10 years and adjusts for inflation, thereby minimizing the effects of business earnings cycles and market fluctuations. This ratio does well to expose S&P 500 companies that have an overvalued stock price, but are only just growing at the rate of inflation. In other words, the Shiller P/E Ratio gives investors the opportunity to evaluate and compare the real stock market returns on a value basis. Therefore, the Shiller P/E Ratio, invented by Professor Robert Shiller of Yale University, is seen by some investors as a more accurate representation of how overvalued the overall stock market really is.

The Shiller P/E Ratio calculation is shown below:

Shiller P/E Ratio = Share price / (10-year average inflation - Adjusted earnings)

Fortunately, you do not have to calculate this, as it's once again available on multpl, where you can view an up-to-date graph of the Shiller P/E Ratio. Again, if we reduce this time frame to only be from 1970 - 2021, we can get a better picture on whether the stock market is overvalued or not, as shown below:

For reference, below are the historical averages for the Shiller P/E Ratio (data from multpl):

  • Average (1870 - 2021): 16.79
  • 50-Year Average (1970 - 2021): 20.6
  • 25-Year Average (1996 - 2021): 27.55

As you can see, even after earnings are averaged-out and adjusted for inflation, the stock market still appears to be on the high end. Currently, the Shiller P/E Ratio is hovering around 35, which is the highest it has ever been in history, besides in the 2000's when the Dotcom Recession occurred.

Sector S&P 500 P/E Ratios and Shiller P/E Ratios

Besides analyzing the overall S&P 500 P/E Ratio and/or the Shiller P/E Ratio, investors should take a closer look at the individual sectors within the S&P 500 to identify whether they too appear overvalued. In other words, just because the overall market appears overvalued, doesn't mean that every sector within the S&P 500 is as well.

Below is a range plot comparing the S&P 500 P/E Ratios and Shiller P/E Ratios of the 11 main sectors within the S&P 500:

From this, we can see that utilities, financial services, energy, and consumer defensive all appear to be industries that may be worth looking into further, at least relative to the P/E ratios of other industries within the S&P 500. However, every industry will naturally have a lower or higher P/E ratio (i.e., technology is usually always higher than utilities), so these ratios should also be compared to the historical averages within the industry.

The Energy sector currently has a negative P/E ratio due to the effects COVID-19 had on the industry and appears to be undervalued. Therefore, there may be multiple undervalued energy companies within the S&P 500 that can offer a good buying opportunity for investors. In fact, Warren Buffett bought Dominion Energy (D) in 2020, an S&P 500 energy company. This helps to support the suggestion that undervalued buying opportunities do still exist in an overvalued market.

Lastly, it's important to mention that neither the S&P 500 P/E Ratio or the Shiller P/E Ratio can be applied to all industries. In particular, this applies to real estate investment trusts (REITs), where the funds from operations (FFO) is a much more useful valuation metric. The P/E ratio is not very useful for the financial services industry either, as the price-to-book (P/B) ratio is a lot more relevant.

S&P 500 Dividend Yield

Dividend yield is the ratio of a company's annual dividend compared to its current share price, which can be applied to the S&P 500 Index as well to determine if the market is overvalued or not.

The dividend yield calculation is shown below:

Dividend yield = Annual dividend / Share price

When stock prices are at relatively cheap levels, dividend yields will typically be higher. However, when stock prices grow faster than they can grow their dividends, you will see lower dividend yields. Therefore, if companies within the S&P 500 have high equity valuations but relatively low dividend yields, this can be a sign of an overvalued stock market. It's also a sign of a less-attractive stock market for dividend investors because of the lower dividend yields, which is especially important because 405 companies in the S&P 500 paid a dividend going into 2020.

Again, you can use multpl to view a chart of the S&P 500 dividend yield. If we reduce this time frame to only be from 1970 - 2021 we can take a closer look at where the S&P 500 dividend yield is now:

For reference, below are the historical averages for the S&P 500 Dividend Yield (data from multpl):

  • Average (1870 - 2021): 4.31%
  • 50-Year Average (1970 - 2021): 2.86%
  • 25-Year Average (1996 - 2021): 1.85%

The current S&P 500 dividend yield of 1.52% falls short of these averages and therefore indicates an overvalued stock market, which at the very least, is unattractive for dividend investors. Regardless, these lower dividend yield averages can (again) be something to keep in mind and re-analyze as time passes.

Buffett Indicator

The Buffett Indicator, popularized by Warren Buffett, compares the size of the stock market (according to market capitalization) to the national gross domestic product (GDP). The theory is that as GDP rises, regardless of the country, the stock market should logically rise as well. Therefore, if the GDP and stock market grew at the same rate, the chart would be relatively flat.

The Buffett Indicator can be calculated using the formula below:

Buffett Indicator = Stock market cap / Nation's GDP

With the Buffett Indicator, you're looking at the market capitalization of the overall stock market, and then comparing this to how much companies within the stock market are actually producing for the economy, represented by GDP. Therefore, the larger the distinction between the economy and overall performance of the stock market, the higher the Buffett Indicator figure.

Again, you do not have to calculate this, at least for the U.S. stock market. This chart can be found on FRED or Longtermtrends, where the Wilshire 5000 Total Market Index is commonly used to represent the market cap of the overall U.S. stock market. It's also displayed below in more detail:

For reference, below are the historical averages for the Buffett Indicator (data from Longtermtrends and Current Market Valuation):

  • Average (1950 - 2021): 76%
  • 50-Year Average (1970 - 2021): 84.49%
  • 25-Year Average (1996 - 2021): 105.55%

In 2001, Warren Buffett described the Buffett Indicator as "the best single measure of where valuations stand at any given moment." Buffett also mentioned that "if the ratio approaches 200%... you are playing with fire." Currently, the Buffett Indicator is hovering around 200%, which obviously suggests that the overall stock market is strongly overvalued.

S&P 500 Mean Reversion

"Mean reversion" refers to the financial concept that a stock's price (or an index like the S&P 500), over the long-term, will always fluctuate around its mean. Therefore, if the market had a positive/negative change to its actual returns, mean reversion would cause a negative/positive change afterwards at a non-particular speed.

As you might've guessed, when the current stock price is less than this historical average price, the stock is considered undervalued. On the other hand, when the current stock price is above the historical average price, the stock is considered overvalued.

The S&P 500 Mean Reversion chart can be graphed using inflation-adjusted S&P 500 returns and an exponential regression trend line, as shown below from 1970 - 2021:

On Current Market Valuation, you can view an up-to-date S&P 500 mean reversion chart to get a closer look on whether the S&P 500 is over- or undervalued. The "S&P500 Detrended" chart on this page is particularly useful to compare S&P 500 performance to prior peaks. However, as the mean reversion chart above suggests, the stock market is overvalued.

Interest Rates and Bond Returns

Interest rates, or the cost of borrowing money, are driven by the supply and demand for credit. Interest rates in the U.S. are heavily influenced by the U.S. Federal Reserve (the Fed), to stimulate economic growth for the U.S. economy. The Fed can therefore lower interest rates to lower financing costs, which encourages individuals and corporations to borrow and spend more, thereby stimulating economic growth. If there's too much growth and the U.S. dollar begins to weaken from inflation, then the Fed can simply raise interest rates to return growth to a more sustainable level.

You can view an up-to-date Effective Federal Funds Rate on FRED. As of January 2021, this is sitting at 0.09%, at the near-zero levels it has been hovering at for just over a decade now. For reference, this is shown below as well:

| Stablebread
Source: FRED

From the perspective of a low interest rate environment, stock markets aren't overvalued, which contradicts what other indicators in this article have clearly shown as an overvalued stock market. Again, this is because low interest rates encourage spending and borrowing. When companies are borrowing more debt to grow their earnings and more investors are investing in the stock market, this will naturally cause the overall stock market to continue moving higher.

Another reason that the stock market continues to rise, is because these low interest rates have made most bond investments an inferior asset class. You can view the most recent 10-year Treasury yield rate on USDT, which as of 02/26/2021 is sitting at 1.44%, with shorter-maturity Treasury yields offering even lower interest rates. Therefore, even though the U.S. stock market may appear overvalued, investors are still investing in the stock market because bonds (and banks) are not worthwhile investments with their low interest rates. Investing in these fixed income securities can even lose you money, because the inflation rate (based on the Consumer Price Index (CPI)) is currently at 1.4%.

In short, it's only when the U.S. dollar begins to weaken to a certain level and inflation begins to rise to a non-acceptable level of inflation, that the Fed will step in and increase interest rate levels. Only then will the stock market appear overvalued from an interest rate perspective.

Yield Curve Inversion

The yield curve is a curve that visualizes the difference in interest rates between different U.S. Treasury bond yields. If you take these Treasury bonds of varying maturities, plot their yields on a chart, and connect the dots, you will typically end up with a curve like the one shown below:

When the yield curve is positive (normal), as shown above, the yield of short-term bonds will always have lower yields than those of long-term bonds. However, if investors expect future interest rates to fall or for their stock market investments to perform poorly for whatever reason, they would purchase long-term (i.e., 10-year) bonds at higher yields. This has the potential to increase demand for these longer-term bonds to an extent to which the yield curve will flatten, thereby causing long-term bonds to be no more attractive than short-term bonds.

Although a flat yield curve can sometimes return back to normal, what can result afterwards is an inverted yield curve. This means that short-term bonds are offering higher interest rates than long-term bonds, which is widely regarded as a bad sign for the economy.

The reason this matters, is because the inverted yield curve is a strong leading indicator of an upcoming recession. As of writing, the yield curve has correctly predicted the last 6 recessions over the past 5 decades, even if there's a 7 to 24 month delay before a recession even occurs after the yield curve inverts.

This is shown below, with the red arrows pointing to when the yield curve inverted and the vertical gray bars indicating recessions:

| Stablebread
Source: FRED

Therefore, as the market begins to appear more overvalued and investors begin to buy long-term bonds to lock-in the highest available yields, it may be a sign of an overvalued stock market. At the very least, it's a sign of a market that is at-risk of crashing soon. So, although the yield curve has not flattened or inverted recently, when it does it could be a sign of an overvalued stock market. However, at the moment the yield curve is suggesting that the U.S. stock market is fairly valued.

The Bottom Line

In summary, as of writing, it's fair to say that the stock market is overvalued, close to strongly overvalued, and is being driven higher due to near-zero interest rates and a positive-sloping (aka normal) yield curve.

If the stock market does appear to be overvalued, this does not mean that you should avoid investing in the stock market altogether. Instead, what it implies is that many companies within the stock market are overvalued, which can lengthen the time needed to find good undervalued stocks. As mentioned before, one method to speed up this process is to start with companies within undervalued S&P 500 sectors.

Finally, if you believe the stock market is greatly overvalued and a recession is around the corner, perhaps due to a prolonged inverted yield curve, then it's logical to reduce the amount you invest in the market. In the meantime, you can invest in other asset classes, save more in cash for when the market crashes, and/or spend time evaluating different companies to identify individual market opportunities.

Dollar-cost averaging can of course help to average-out investments in an overvalued broad market, but individual stocks, other asset classes, and saving more in cash may be the ideal way to go. At the end of the day, it's going to be much easier to find and buy good undervalued stocks or simply a market-following ETF when the market corrects itself and no longer appears overvalued.

Disclaimer: Because the information presented here is based on my own personal opinion, knowledge, and experience, it should not be considered professional finance, investment, or tax advice. The ideas and strategies that I provide should never be used without first assessing your own personal/financial situation, or without consulting a financial and/or tax professional.

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