I'd like to start this post off with a disclaimer: Stating facts does not equal wishing for them. It is important to realize that facts are facts regardless of what you or I may think about them. If it were up to me the market would just always go up. Seriously. Who wouldn't want that? This post isn't meant to be uplifting. It's meant to be real. So before you turn on your "information I don't like so it must have a sinister motive" filter instead take a look at facts, see how they make a convincing argument, and consider what they're telling you. I want to share with you where exactly the market is right now. Any time anyone talks valuation there's inevitably a crowd that says "now is different than the rest of history so historical comparisons are irrelevant" consider that one of the signs we're in a market bubble is that very mindset. Every single time in history things have run up to extreme valuations there have ALWAYS been those saying "this time is different." They were wrong. Every. Single. Time. 1929 was different. 1987 was different. 2000 was different. 2008 was different. They all ended the exact same. You can argue valuations stretching to a degree but when you look at where we are absolutely no one can legitimately argue that in the timespan of a decade valuations have shifted 2.6 standard deviations above the historical average. With that, let's look at a wide variety of historical market valuation metrics and where they currently stand.
First it's important to define the term standard deviation.
Standard deviation is a basic mathematical concept that measures volatility in the market or the average amount by which individual data points differ from the mean. Simply put, standard deviation helps determine the spread of asset prices from their average price. When using standard deviation to measure risk in the stock market, the underlying assumption is that the majority of price activity follows the pattern of a normal distribution. In a normal distribution, individual values fall within one standard deviation of the mean, above or below, 68% of the time. Values are within two standard deviations 95% of the time. So something outside of 2 standard deviations has a 5% or less chance of occuring.
1) Buffett Indicator
The Buffett Indicator is the ratio of total United States stock market valuation to GDP. Named after Warren Buffett, who called the ratio "the best single measure of where valuations stand at any given moment".
The current market-to-GDP ratio is 69% (2.2 standard deviations) above the historical average, sitting at all time highs, and considered Strongly Overvalued.
⭐US Market Value $51.1T
⭐US GDP $23.7T
⭐Buffett Indicator 216%
⭐Historical Ave BI 124%
⭐Std Dev above trend 2.2
2) P/E Ratio
The P/E ratio is a classic measure of any security's value, indicating how many years of profits (at the current rate) it takes to recoup an investment in the stock. Just like you can use earnings to determine an individual stock's P/E ratio, the same analysis can be done to the entire stock market. By adding up the price of every share in the S&P500, and comparing that to the sum of all earnings-per-share generated by those companies, you can easily calculate the P/E ratio of the US stock market. The current S&P500 10-year P/E Ratio is 38.5. This is 95% above the modern-era market average of 19.6, putting the current P/E 2.4 standard deviations above the modern-era average. This suggests that the market is Strongly Overvalued.
⭐P/E (CAPE) Ratio 38.5
⭐Historical Ave PE 19.8
⭐ % above trend 95%
⭐Std Dev above trend 2.4
3) Mean Reversion
Mean reversion is the fairly unsophisticated concept that "what goes up must come down". It is generally true that while the day-to-day movements of the stock market are chaotic and unpredictable, long term stock market returns tend to adhere to somewhat predictable upward trends. Deviations from the trend can last years, or even decades, so this is not a helpful short term trading strategy - rather, a useful indicator of overall market valuation relative to modern history. Mean reversion isn't a theory. It's a reality. Again and again and again it is proven. The down decade of the 70's reverted into the roaring 80's and 90's. That reverted into the lost decade of 2000-2010, that reversed into the bull run of 2011-2021. You can see this pattern repeating itself over and over in the market. Extremes, whether to the low end or the high end, are counteracted eventually by an opposite extreme which brings things back to the average. These cycles are not exact down to the day but you can see in the chart attached that they tend to run a decade peak to trough.
⭐S&P500 Price $4,595
⭐S&P500 Trend Price $2,300
⭐% above trend 91%
⭐Std Dev above trend 2.6
Those are 3 examples of market overvaluation but not even close to the only 3. I included a chart and a table below with other metrics and how those stack up historically.
Let's get away from market metrics and ratios and talk about how to look at this in a way that everyone can relate to. I keep seeing the argument made that everything is at a discount now so it constitutes a buying opportunity. The problem with that is it isn't consistent with how anyone views prices in any other context. What do I mean? Let's say that tomorrow I start selling one pound of chicken for $100. After a few weeks of doing that I decide to give people a break and lower the price to $75 a pound. Technically based on my previous price you could say that chicken is selling at a discount. But is it really? We know from the context of every day living that chicken has never sold for anywhere near $100 a pound. A $25 discount, while cheaper, is still ridiculously more expensive than chicken has ever been in our lives. Based on how people view the market, we should see $75 chicken as a buying opportunity. Another example. 10 years ago you buy a car for $5000. Would you be willing to pay $50,000 for that same car today? Unless something unusual and significant occured making that car more valuable every single person would question the price rise vs the historical precedent. Why then are we treating stocks differently? Yes the last few weeks have seen more red days than green. The problem with assuming that equals a buying opportunity is that we're looking at $75 chicken. Based off of all known historical valuation methods we are, even after the drops, SIGNIFICANTLY above historical averages. Just as you would never buy that 10 year old $5000 car for $50,000 without some serious investigation into why the price jumped so much you shouldn't blindly buy a stock price decline without first knowing how to contextualize the price it fell from, where it is currently, and whether or not that fits within a historical context of how stocks are valued.
If you are making the argument that suddenly this stock is worth this much more per dollar earned than at any point in history you should at least have a convincing argument as to WHY that premium is suddenly justified. More importantly than the present, what reasoning do you see that this valuation will CONTINUE to be warranted. The higher multiple we are willing to pay per dollar earned the higher the expectations, the lower the margin of error, and the less room the stock has for further appreciation in the future. If it's already trading at twice the historical average price per dollar earned that doesn't leave it a ton of room for further expansion.
In the end only you can determine how the facts influence your decision making. As is always the case my only goal is to provide you with facts that I don't see being presented as loudly. Everyone wants the market to go up. I know I certainly do. The facts say that is never the case. Things move up AND down. The overall return for the S&P 500 from 2000-2010 was NEGATIVE. That's a full decade where the market ended up below where it started. That's not some distant far ago past. We've since experienced a full decade of significantly above average returns. It's important to remember that this period also coincided with unprecedented financial stimulus from the Fed. This, and a near zero interest rate environment, contributed HEAVILY to returns. If you look at the S&P 500 chart overlaid with the Fed balance sheet they rise in unison. The Fed this week indicated not only a faster tapering of asset purchases but hinted at a more rapid round of rate hikes. These policies are INTENDED to slow things way down. It shouldn't come as any surprise when these actions have their intended effect.
Be careful. Be informed. Don't assume things are going to quickly bounce back to all time highs. Before you buy the dip be sure that dip isn't a $75 pound of chicken.
#tcardizzle #buythedip #invest #learn
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I couldn't find a way to fit this chart into the post but I highly suggest giving it a look
https://www.currentmarketvaluation.com/posts/2021/07/Fed-Balance-Sheet-vs-SP500.php
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Sources
https://www.currentmarketvaluation.com/
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https://www.morningstar.com/market-fair-value
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https://www.marketwatch.com/story/even-the-most-generous-of-valuation-gauges-shows-the-u-s-stock-market-is-overvalued-11638538149
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https://seekingalpha.com/article/4469430-fed-issues-stock-market-warning-as-valuations-surge
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