6 Ways to Spot an Overpriced Stock Market (Hint – We Have All Six)

In an article posted in August 2016 on MarketWatch.com, columnist Mark Hulbert asserts that the United States stock market is currently more overvalued than at virtually any other peak during the last 100 years. This one fact counters the argument that the current valuation is because the market is at one of its highest points in recent years. Furthermore, Hulbert is not the only financial analyst who believes that the stock market is overpriced and that investors need to be more aware of the ways that they can spot an inflated market.

Key Measurements to Spot an Overpriced Stock Market

Using six different methods of measuring valuation, Hulbert found that the current market is more inflated than it was during 79 percent to 95 percent of all of the bull market peaks that have occurred since 1900.

• The price to book ratio is currently 2.8 to 1. At 23 out of 29 major peaks since the 1920s, the ratio was lower than the current ratio.
• The dividend yield for the Standard & Poor’s 500 index is currently 2.1 percent. Of the 36 peaks in the market since 1900, this yield was higher at 31 of them.
• The price to sales ratio currently stands at approximately 1.9 to 1. Since the 1950s, this ratio was lower at 18 out of the 19 peaks.
• The cyclically adjusted price to earnings ratio is currently 27.2, lower than it was at all but five of the 36 peaks occurring since 1900. This ratio is considered to be a major indicator of an overvalued market by economist Robert Shiller of Yale University. In December 1996, Shiller delivered a speech to the Federal Reserve that discussed “irrational exuberance,” and although stocks continued to climb for the next three years, Shiller was proven correct when the dot-com bubble burst.
• The price to earnings ratio, which is currently 25.2 to 1, is higher than it has been at 89 percent of the market peaks that occurred in the past.
• The “q” ratio is a computation that is based on the research of the late James Tobin, who was a Nobel laureate in economics in 1981. Using this calculation, economists have found that the current market is more overvalued that at 30 of the 36 peaks occurring since 1900.

Overvalued Market Comes as No Surprise to Many

As far back as 2014, many analysts were warning that the market was overvalued. In March 2015, Jeremy Hill contributed an article to Forbes in which he stated that stocks were overvalued when considered on a historical, abstract basis. As Hill notes, buying stocks while they are overvalued tends to yield long-term gains that are below average.

In an article posted July 2, 2016, on Nasdaq.com, author James Li offered information supporting an overvalued market. Li mentioned that Warren Buffet predicts that between 2016 and 2024, the market average will be a slim 40 basis points, or 0.40 percent, which includes dividends. The indicator that Buffet uses is the ratio of the total market cap to the gross national product. Other analysts have stated that the most optimistic annual return for the same period would be 5.4 percent. Based on the Shiller ratio, however, the picture does not look as rosy. According to the Shiller formula, over the next eight years, the projections show an annual loss of 0.2 percent.

Overvaluation of Stocks Not Universal

Not every stock listed on the exchange is overvalued. However, many utilities, telecommunications and real-estate investment trusts are not good choices for those looking for portfolio growth, according to an article appearing on MarketWatch.com. Of the 27 real-estate investment trusts included in the Standard & Poor’s 500, 14 of them have returned 12 percent or more between January 1 and August 11. The utilities sector posted a return of 17 percent during the same period, and the sector’s trailing P/E ratio is higher than it has been since the early part of 2000. However, utilities typically do not go up so much in value, especially when they are already at a market peak.

Will the Outcome of the Presidential Election Affect the Market?

Some analysts believe that uncertainty over the presidential election could be contributing to the market’s low volatility. Others prefer to use market conditions to predict who will win the election. According to an article on MarketWatch.com, during the 90 days immediately preceding a presidential election, the Standard & Poor’s 500 recorded average returns of 8.4 percent when a candidate ended up winning by more than an 80-percent margin. Should Clinton win, the combination of a split Congress and a Democratic president could result in gridlock. With little chance of major changes in economic policies, investors might see a weaker dollar and lower interest rates.

What Will the Market Do Next?

It is important for investors to remember that analysts can make predictions, but no one has the ability to accurately foretell the future. There are simply too many events that could affect the market, including events that occur overseas. However, if you would like to learn more about the stock market, you can find additional resources at the Personal Money Store.

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