Is the U.S. Stock Market Overvalued?

In March 2009, the S&P 500 bottomed at 666. Today it’s about 2,500, that’s a 275 percent increase over 8 years. This (U.S. stocks) bull run has been strong and long lasting. A Trump victory has given credence to the fact that there is “more room to run”. But is that true?

The total market cap (TMC) to GNP ratio, or the Buffett indicator, is “probably the best simple measure where valuations stand at any given moment”. The chart below is the current ratio of total market over GDP (proxy for GNP) and its historical range.

(Source: AdvisorPerspectives.com)

The ratio cannot be used to compare the valuation levels of different nations. Some are driven by large public listed companies, others by state-owned companies. Then there are differences in reporting, accounting rules, regulations and tax laws. Further, some suffer from low equity ownership. For example, India has only 4% of adult population who own stocks compared to 52% in the U.S.

Country	GDP ($Trillion)	Total Market/GDP Ratio (%)	Historical Min. (%)	Historical Max. (%)	Years of Data
USA	19.25	134.9	35	149	47
China	12.43	48	41	662	27
Japan	4.55	150	56	361	33
Germany	3.69	53	13	58	27
France	2.65	92	52	182	27
UK	2.6	124	47	201	45
India	2.46	68	40	158	20
Italy	2.16	15	10	45	17
Brazil	1.97	48	26	106	20
Canada	1.72	121	78	190	27

(Source: https://www.gurufocus.com)

That said, the U.S. current market cap/GDP ratio of over 135 per cent could be problematic, if you subscribe to Buffett’s mantra. As he (Buffett) says, “for investors to gain wealth... the percentage relationship line... must keep going up and up”. And if it gets too high, Buffett says you’re “playing with fire”.

The cyclical-adjusted-price-to-earnings (CAPE) ratio of a stock is another standard metric used to evaluate if a market is overvalued or otherwise. This metric was developed by Robert Shiller of Yale and popularised during the Dotcom Bubble. It’s a variant of the typical price-to-earnings (P/E) ratio of stocks.

When the CAPE ratio is high, it’s usually wise to reduce equity exposure.

CAPE Ratio S&P 500

(Source: http://www.multpl.com/shiller-pe/)

The CAPE and Market Cap/GDP ratio generally correlate closely.

So is the U.S. market overvalued?

Robert Shiller suggests long-term investors to cut back on their equity holdings. At this level, he suggests that “the expected return for stocks might be negative, but only slightly so”. Shiller adds, “... it’s quite reasonable to have an investment in U.S. stocks as part of a diversified portfolio... but don’t go overboard on it”.