For several years, some of us have value investors have complained about the markets in the U.S. being overvalued. So, have valuations finally dropped to the point where markets like the New York Stock Exchange and the Nasdaq are fairly valued?
Here’s what has happened with the S&P 500 over the past three months, as shown in this GuruFocus graph of the GSPC (GSPC, Financial) exchange-traded fund representing the S&P 500 (without dividends):
Those are serious declines, and according to many market observers, we have entered bear market territory. However, based on two GuruFocus indicators, the markets are still overvalued.
Shiller P/E
The first is the Shiller P/E or CAPE ratio indicator, created by Robert Shiller, a professor at Yale University and a prominent author. GuruFocus showed this reading at the close of trading on Friday, March 13, 2020:
What does this list show us?
- The Shiller P/E stood at 26, which was a 9.287% increase from Thursday, March 12.
- At 26, the ratio is 52.8% higher than its historical mean of 17.
- The implied return, which is what we might expect if we bought the market at the current price, is 0.2%. In other words, to buy at these levels you would overpay and as a result, your return is forecast to be less than 1%.
- The historical low for this ratio is 4.8 (in 1920) and the historical high was 44.2 (in 1999), just before the dotcom crash.
- Regular P/E (that is, not cyclically adjusted like the Shiller P/E is) is 20.4, which is also above the historical mean of 16.1.
Here’s what the Shiller P/E has done long term, since 1881:
Here, we zoom in on the Shiller P/E for the past five years:
In the past five years, the lowest point was in September 2015, when the index dropped to 24.50, and the highest was in September 2018, when it hit 32.60.
Buffett Indicator
The second GuruFocus market valuation indicator carries the name of Warren Buffett (Trades, Portfolio), the legendary chairman of Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial). His measure is based on the total market capitalization of U.S. companies and U.S. gross domestic product (GDP). This chart, with GDP in green and the total market cap in blue, shows their relationship over the past four decades:
Note how the GDP grows quite consistently, with the only notable exception being the financial crisis of 2008. At the same time, total market capitalization fluctuates above and below it. Because the total market cap is based on share prices (multiplied by the total number of shares outstanding), it fluctuates with the moods of the market.
We can also see that the investors have been in a buoyant mood for the past 11 years, bidding up the prices of stocks without regard to the underlying drivers of corporate profitability. Total market cap has reached $30 trillion, while GDP has risen to just $20 trillion.
Using the Buffett indicator, the market is considered “Significantly Overvalued” at 124.9% on March 13. GuruFocus provides this table showing how the various ratios are described:
At the current level, the implied return is 0% annually, which is close to the level implied by the Shiller P/E. To calculate the implied return, sum up the dividend yield, the amount of business growth and any change of valuation (all in percentages).
Sector valuations
As we saw above, the Shiller P/E can be used to indicate whether the overall market is overvalued, fairly valued or undervalued. It can also show us how individual sectors are valued; this GuruFocus table shows how they looked at the close of trading on Friday.
Obviously, anyone brave enough to buy oil and gas or other energy stocks these days will find some excellent prices, but whether they find excellent value will depend on lots of due diligence. They are significantly undervalued.
On the other hand, you’d also have to be brave to invest in real estate stocks at the moment. There is undoubtedly value in the sector, but you would pay very dearly for it. In fact, without even getting out our calculators, we recognize the implied returns are going to be negative if we buy now.
Elsewhere on the list, one other sector (financial services) is undervalued, and nine sectors are overvalued. That tells us that overvaluation is built right into the market-wide overvaluations.
Conclusion
Here are my three basic strategies for various market conditions:
- If the market is fair-valued or modestly overvalued, buy high-quality companies.
- If the market is undervalued, buy a basket of low-risk, “beaten-down” stocks.
- If the market is seriously overvalued—as it is now—stay in cash.
As value investors, our goal is to always buy stocks and other equities at a discount, to ensure we have a margin of safety. While there are undoubtedly a few stocks that are undervalued now, most will still be overvalued.
That means prudent investors will continue to wait for better values, which may be available soon if the market continues to slip almost every day.
Read more here:
- Book of Value: Investing as a 'Negative Art'
- Book of Value: Purveyors, Victims and the Stock Market
- Book of Value: Shady Influences
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