By any historic metric, this market is getting closer to the edge
The evidence is piling up.
It’s been a great run, the best two-year romp for the S&P 500 since the late 1990s, with a bit of a Santa Claus rally perhaps still to come.
But allow me to be the proverbial fly in the eggnog and note the fact that several of the market’s most time-tested valuation metrics appear to be flashing a giant, red warning signal, complete with sirens.
I know, I know. Valuation is a bit of a quaint concept for today’s investors, who are enjoying gobsmacking gains from electronic crypto doodads and newly minted AI-related behemoths.
But traditionally, the market’s ability to keep climbing is contingent on the earnings that companies are able to generate, the expansion of the economy, and the relative risks and rewards of letting your money ride in the stock market or enjoying safe and steady fixed income on the sidelines. On all those counts, the level of prices on stocks is stretching the limits of traditional stock-market logic.
As I’ve said before, the standard forward price-to-earnings multiple of the S&P 500 right now suggests investors are paying a historically high premium for exposure to the market.
But other longer-term iterations of price-to-earnings metrics, like Yale University finance professor Robert Shiller’s Cyclically Adjusted Price-to-Earnings Ratio (CAPE), clearly shows the market is at some of its most expensive levels in history.
For instance, stocks are far more expensive — in terms of their actual earnings over the last decade — than during the bull market of the 1920s, which ended cataclysmically in 1929. The only time on record when they were pricier was during the dot-com boom of the late 1990s, which had a kind of disappointing finale as well.
Another way to look at the markets is their capitalization as a percentage of the total economy. This yardstick is sometimes known as the Buffett Indicator because of the fact that it’s one of Warren Buffett’s favorites. It has been going nuts recently, rising into never-before-seen territory, with total capitalization of the stock market — roughly $55 trillion — approximately double the size of the US GDP. (Of course, US companies, especially the multinational megacap tech giants, have seen foreign sales swell as a share of total revenues, so the utility of having the US economy as the denominator has diminished over time.)
In a 2001 piece in Fortune, the Oracle of Omaha said, “If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200% — as it did in 1999 and a part of 2000 — you are playing with fire.”
No wonder Buffett has been building cash.
All the above warnings signals are derived from the stock market in isolation. But the whole idea of building a portfolio is to weigh your options across asset classes. That’s why looking at the “equity-risk premium” can be helpful.
This chart basically gives you an estimate of how much the market is compensating shareholders for putting their money at risk on the equity-market rollercoaster versus the virtually guaranteed rewards of sticking your cash in government bonds. (Yields there are still high, by the way, with three-month Treasury bills paying almost 4.50%.)
As you can see, you’re getting what’s known on Wall Street by the technical term of bupkis.
Of course, valuation metrics are famously terrible tools for timing the market. Just because the stocks appear insanely overvalued at the moment, it doesn’t follow that the market is in danger of an imminent collapse.
There are even some reasons why these metrics might be less helpful than they’ve been in the past. For instance, we’ve never had companies in the stock market as big as they currently are in terms of market capitalization. (Apple, Nvidia, and Microsoft are all worth more than $3 trillion.)
That might just reflect the fact that those companies are more powerful players in the economy and thus it makes sense that market capitalization to GDP would be higher than it has been historically.
Likewise, the incoming Trump administration is widely expected to loosen regulatory rules and cut taxes, meaning that the market could be pricing in higher profits than usual going forward. Sure, maybe. But if the market does take a header, or even merely stalls out for a while, don’t be too surprised.
