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Overvalued Markets, Big Decisions & Cherry-Picking with Nick Maggiulli

FEATURING RITHOLTZ WEALTH MANAGEMENT’S, CHIEF OPERATING OFFICER, NICK MAGGIULLI @DOLLARSANDDATA

One of the biggest questions on investors’ minds today is whether the stock market is overvalued. After all, if you look at the data, it seems abundantly clear that prices have outpaced fundamentals (i.e. earnings) over the past couple of years.

For example, from January 2020 to June 2021 the level of the S&P 500 increased by 36% while earnings went up by only 14%:

Download Visual l Modify in YChartsYou can go back further in time and come to the same conclusion. If you start in January 2016, you would see that prices have outpaced earnings by more than 50 percentage points  in total:

S&P 500 Earnings Vs. Total Return since January 2016

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You can even go all the way back to 2000 (when market prices were elevated due to the DotCom Bubble) and tell the exact same story—prices have grown more than earnings:

S&P 500 Earnings Vs. Total Return since January 2000

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Case closed, right? Not so fast. The issue with this analysis is that it isn’t as simple as it seems. 

Because if you change the time period you start in, you can come to the opposite conclusion. For example, if you started in January 2009, you would see that earnings have grown by far more than prices:

S&P 500 Earnings Vs. Total Return since January 2009

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Yes, market earnings were depressed during January 2009, so starting at this point might be a form of cherry-picking, but it demonstrates how nuanced this discussion can be.

Based on prices and earnings alone, the market does seem overvalued relative to history. However, since bond yields are lower than they have ever been, some have argued that these valuations may be less extreme than we think. But what do other measures of valuation suggest?

 

What Do Other Measures of Valuation Say?

As we have seen on YCharts previously, metrics such as The Buffett Indicator, which is a measure of total market capitalization of stocks over GDP, is also quite high relative to history:

US Total Market Capitalization since 1971

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While this looks alarming on its face, as I mentioned previously, lower bond yields could be the reason why asset prices are being bid up across the board.

Lastly, the greatest predictor of future stock market returns (the average investor allocation to equities) suggests that future equity returns are probably slightly negative for the next 10 years. Note that this measure currently sits at about 0.51:

Download Visual

And using the analysis from we can see that, at this level, the projected equity returns for the next 10 years are around -2% annually:

Download Visual

There are arguments to be made as to why this measure may not hold anymore, but, either way, I understand why investors are concerned.

 

What Should You Do In an Overvalued Market

While the data suggests that markets are overvalued to some extent, this doesn’t mean that you need to make major changes to your portfolio. If you had done this a few years ago (when these valuation measures were also elevated), you would have missed out on quite the  rally. 

Therefore, outside of normal rebalancing, I wouldn’t recommend any big changes to your portfolio. Markets can stay overvalued for a long time, so trying to time them is near impossible. 

However, if you are still feeling skittish about buying more U.S. stocks, consider shifting some of your future investments into assets that seem less overvalued (i.e. emerging market stocks, real estate, etc.). So if you would normally  put 50% of your new investments into U.S. stocks, maybe reduce that to 20%-30% and send the  extra money to assets elsewhere.

At the end of the day we do not know what the future holds, so the best investment strategy is to be cautious, but not reckless.

RITHOLTZ WEALTH MANAGEMENT'S, CHIEF OPERATING OFFICER, NICK MAGGIULLI

Nicholas Maggiulli (@DollarsAndData) is an investor, writer, and data scientist. He is currently the Chief Operating Officer at Ritholtz Wealth Management and the author of Just Keep Buying: Proven Ways to Save Money And Build Your Wealth. He resides in New York City but is originally from Southern California.

 

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