Summary · There are varied opinions as to whether the US stock market is in bubble territory.
· It is important to look at valuations from multiple angles before coming to a conclusion.
· Based on our composite valuation indicator, which takes into account five different factors, the US stock market appears to be mildly overvalued but not in bubble territory.
Investment experts disagree In a CNBC article, Goldman Sachs said “any way you look at it, this stock market is overvalued”. James Montier, strategist at GMO which has $77 billion in assets under management, also believes the stock market is overvalued and he is famous for having predicted correctly past market crises. However, we have opinions in the opposite camp. In a March 2017 Forbes article, Warren Buffett said that he believes the stock market is not overvalued and we should stay invested.
How about the financial experts in academic circles? What do they have to say about the valuation of the US stock market?
Robert Shiller, Nobel Prize winner in 2013, has come up with the Cyclically-Adjusted PE (known as “CAPE” or “Shiller PE”), which shows the US stock market to be at the third highest point in history. CAPE is calculated by dividing the current price of the index by the average earnings of the S&P 500 Index companies over the last 10 years.
* Shiller PE of 30.49 as at 19 August 2017
Source: Manager Mint Media
Jeremy Siegel, Professor of Finance at the University of Pennsylvania, however does not believe that the market is overvalued. In a CNBC article, he said that the CAPE is artificially high because it incorporates the low earnings during the time of the global financial crisis.
Valuing the stock market from the bottom up
When we value stock markets, we should remember that we are actually valuing the stocks in that market. Therefore, we should approach it in the same way we value individual stocks. The only thing different is that we aggregate the analysis of all the stocks to give us a picture of the entire market.
When we value individual stocks, we should look at multiple factors and not just one. Each valuation indicator has its pros and cons and we don’t really get an accurate picture until we put them all together.
Furthermore, when we want to decide where a stock is heading, we don’t just look at history, we look at future estimates as well. For example, we don’t just say, “Current PE is high.”, we should also look at the trend of the underlying earnings for the next two or three years.
Using this approach, we valued the US stock market bottom-up using five different indicators that analysts would use to value stocks – Price to Earnings, Price to Sales, Price to Cash Flow, Price to Book and Dividend Yield. Then we put them all together into an optimized Composite Valuation Indicator to tell us whether the stock market is overvalued or not.
Based on the above bottom-up analysis, we conclude that the US stock market is extremely overvalued based on Price to Sales and Price to Cash Flow, mildly overvalued based on Price to Earnings and Price to Book and fairly valued based on Dividend Yield. Putting them all together in an optimized way, the Composite Valuation Indicator points to the conclusion that the US stock market is mildly overvalued.