What 5 Measures of Market Valuation Are Saying Right Now
With the notable exceptions of Q4 2018 and March 2020, US equities have enjoyed a largely uninterrupted ride higher since the Financial Crisis bottom in early 2009. But the exponential run by stocks since the COVID-19 selloff has plenty of us asking: is the market overvalued? And is a correction coming?
To offer perspective on life’s—well, the market’s—big questions, here are five measures that illustrate where market valuations currently stand:
1. S&P 500 Price to Earnings Ratio
The S&P 500 P/E Ratio measures the combined price of all 500 constituents against their aggregate earnings-per-share. Its latest reading from Standard & Poors, 30.99 as of Q1 2021, means investors are paying $31 for every dollar of earnings from all S&P 500 stocks.
Compared with a historical average of 24.4, the S&P 500 would be considered overvalued on the basis of its P/E ratio. However, it’s worth noting the S&P 500 earnings per share forward estimate is projected to grow through Q4 of 2022, which will dampen the S&P 500’s forward P/E ratio. Projections indicate an index P/E ratio of 24.8 for Q4 of 2021, and 22.2 for Q4 of 2022. (That’s a lot of 2s!) Assuming price growth slows or remains flat, the S&P 500 might actually trade at a discount to historical averages. If prices run away, well…
2. S&P 500 Shiller CAPE Ratio
Similar to P/E ratio, the Shiller Cyclically Adjusted Price-to-Earnings (CAPE) ratio divides the S&P 500’s current price by its 10-year moving average of inflation-adjusted earnings. Followers of CAPE anticipate a higher ratio could reflect lower returns over the next couple of decades, whereas a lower figure would indicate higher returns over the same period.
Formerly, when the CAPE ratio went above its historical average, it didn’t stay there for long — but since the 1990s, that trend has reversed. Spikes in the CAPE ratio have often preceded recessions, and with the metric currently approaching its highest level on record, those who abide by CAPE will be watching for any reversions to the mean.
3. The Buffett Indicator
US Market Capitalization as a percentage of GDP is “probably the best single measure of where valuations stand at any given moment,” according to the indicator’s namesake, Warren Buffett. The ratio measures the aggregate value of the US stock market relative to the country’s economic output, and is currently at its highest level ever. Investors are paying over 2x for every dollar of US GDP, compared to a long-term average of 82 cents. The Oracle of Omaha, known for value investing, is probably not adding equity positions right now, given that the Buffett Indicator is well above its historical average.
4. S&P 500 Dividend Yield
Assuming all else equal, a falling dividend yield means rising prices. With the S&P 500 Dividend only slightly lower than its 2020 all-time high, higher prices for equities are mostly responsible for the S&P 500 Dividend Yield hitting a 20-year low. During the 2010s, the aggregate dividend yield stayed within a consistent range despite a decade-long bull market. Now, as it has tumbled to nearly 60 basis points below its historical average, the only ways for the S&P 500 dividend yield to increase would be dividend hikes by companies—or a correction in the index.
5. The Yield Curve
Long-term treasury rates are almost always higher than those of shorter-term instruments. When the reverse happens, however, it signals shaky confidence in the economy, and typically leads investors to shift from stocks to bonds. This phenomenon, known as an inverted yield curve, has rather consistently foreshadowed recessions and market downturns.
The 10-2 and 10 Year-3 Month Treasury Yield spreads were negative right before each of the four recession periods shown above occurred—and the S&P 500 turned negative shortly thereafter. To bullish investors’ relief, the yield curve is currently normal, with both spreads sitting right around their historical averages.
Is a Market Correction Coming?
Corrections can occur in different ways. Most people think of price corrections, such as the S&P 500 falling 10% as a reversion to its long-term mean. But corrections can also come from prices staying flat despite company growth—rising earnings, sales, book value, among others without price increases can result in discounted valuations (see: the S&P 500’s forward P/E ratio). Either way, the market has always ebbed and flowed over time, oscillating between overvaluation and corrections, but the long term trend is a positive one.
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