The US Stock Market: An Impending Avalanche?

The US stock market is valued higher than before the 2007 Financial Crisis. Should we be worried?
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The US stock market is valued higher than before the 2007 Financial Crisis. Should we be worried?

The value of US stocks in the stock market is at an all-time high. They are overvalued, and we all know that. It is undeniable that by any traditional measures of valuation, US stocks are expensive. 

But do we realise exactly how expensive they are?

A recently published paper from value investor GMO gives insight to how expensive they really are, and they are possibly even more overvalued than we think. Going by the Shiller P/E ratio (also known as Cape), which averages earnings out over a ten-year period in order to capture the effect of a whole business cycle, the market has only previously been this overvalued during 1929 and 1999.

Some criticise the Cape measurement, arguing that including the 2007-2008 financial crisis years pulls down the average. As such, the paper also looked at an alternative measurement, the Hussman P/E ratio, which excludes the low-earning years. Going by this measurement, the results were even worse, indicating that the market is more expensive now than in 1929, with only 1999 surpassing it.

The idea here is that, unless investors are now permanently willing to pay a lot more for equities than in the past, or that sustainable profit margins are constantly higher now than in the past, stocks are simply overvalued. Jeremy Grantham, founder of GMO, speculates that this phenomenon can last for some time, especially while interest rates remain low.

Furthermore, the GMO paper talks about “deep value” stocks, based on the Ben Graham criteria. Using this measurement to look for stocks in late-2008 shows the result that approximately 5% of the US stock market could fall under the category of “deep value”, while approximately 20% of Japanese stocks could. Today, only about 5% of Japanese stocks are considered “deep value”, only 2% of UK and European stocks, and a shocking 0% for the US.

And guess what? 

It does not stop there. 

These measures of overvaluation are validated by the biggest banks like Goldman Sachs and Bank of America Merrill Lynch. Goldman warned that the stock market has an “elevated valuation on almost every metric”. 

A report published by a team led by chief equity strategist David Kostin, mentioned that the forward P/E multiple of the S&P500 has risen by over 80% since 2011 and trades at the 89th percentile compared to the past 40 years while the typical individual stock is at the 99th percentile of historical valuation. 

Merrill Lynch’s fund manager survey of global surveys returns a result of 83% of fund managers having the sentiment that US stocks are overvalued. FactSet also analysed and noted that the trailing 12 months P/E ratio for the stock market is 22.1, surpassing the 10-year mean of 16.7. 

This has become such a phenomenon that the biggest investors in the world have made efforts to keep a watchful eye of it, amongst which are Ray Dalio, Larry Fink, Paul Tudor Jones and Leon Cooperman. 

They all hold the sentiment that the value of the stock market, relative to the size of the economy, should be terrifying; holding the expectation of an impending 10% up to 40% stock plunge sooner or later.

At the end of the day, who knows where this stock market is leading to. The caution flags are out, and the sentiments largely shared worldwide. Yet, the stock market continues to rise like never before. 

What’s worrying, is that people never saw our previous financial market collapses happening, until it started to happen. The real question then, is whether we’ll be able to out-think the market this time, or will the market surprise us once again with an eventful purging?

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