Over the past week, the novel Coronavirus, or Covid-19, has taken a toll on the U.S. stock market. However, the U.S. stock market has been considered to be overvalued for years. After taking the recent declines into account, is the U.S. stock market now fairly valued or undervalued, or does it remain overvalued?
Below is a GuruFocus chart showing the price of the ^GSpC, a Goldman Sachs product that reflects the S&P 500 without dividends. Generally, it is comparable with the SPDR S&P 500 ETF (SPY).
As you can see, it’s taken quite a tumble since peaking on February 18, but it is not yet back to fair valuation territory. We know that because we have two GuruFocus tools that allow us to quickly check the state of the S&P 500.
The first is the Shiller P/E or CAPE ratio. As the full name suggests, this metric uses a price-earnings multiple over a full market cycle (set at 10 years, normally). It is shown as a five-year chart:
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The GuruFocus page showing the Shiller P/E ratio also provides the information in numbers:
- Shiller P/E: 28.5 (%).
- The historical mean of the Shiller P/E: 17.
- Overvaluation: 67.6%.
- Implied future annual return: -1.1%
Note the implied future annual return, which is currently in negative territory. This means that the market is overvalued, and an investment in an overvalued market is likely to generate a loss.
However, this is an improvement over its standing on Feb. 20, just 10 days ago, on which the Shiller P/E page showed the following statistics:
- Shiller P/E: 32.3 (%).
- The historical mean of the Shiller P/E: 17
- Overvaluation: 90%.
- Implied future annual return: -2.8%.
The implied future return was 1.7% worse on a roughly 4-point difference in the Shiller P/E.
The second GuruFocus tool that estimates the current market valuation is the Buffett Indicator, named after the master investor Warren Buffett (Trades, Portfolio). It is based on the relationship between a country's GDP (gross domestic product) and the total market capitalization (TMC) of its companies. Buffett calls this ratio “probably the best single measure of where valuations stand at any given moment.”
This chart shows the relationship between U.S. GDP and TMC over the past 50 years:
As we can see, there was a relatively close relationship between GDP and the total market cap until recently. Even during the bubbles and busts of 1999-2000 and 2008-2009, the relationship was fairly close, but since 2013, total market cap has been getting further and further ahead of GDP.
As of the close of trading on Feb. 28, 2020, the Buffet Indicator stands at 146%, which is considered “Significantly Overvalued." Based on the ratio, investors should expect a return of -2.1%, including dividends, if they invest when the indicator is at this level.
There are several factors behind the returns generated by the indicator, primarily the following:
- Interest rates.
- The long-term growth of corporate profitability.
- Market valuations (reverting to their means).
The inicator also considers that the returns from investing in individual stocks or stock markets can be attributed to:
- Business growth.
- Dividends.
- Changes in market valuation.
From this second set of criteria, they offer a formula by which likely market returns can be calculated: “Investment Return (%) = Dividend Yield (%) + Business Growth (%) + Change of Valuation (%).”
Aggregated Guru Portfolios
So, what are we to do when market valuations are still high? The Buffett Indicator page on the GuruFocus website recommends that we check out the Aggregated Guru Portfolios for potentially undervalued stocks.
At the Aggregated Guru Portfolios page, we see a list of gurus, and we can select the portfolio(s) of one, some or all 177 of them. There are also a couple of screening sliders that allow us to pick portfolios of various sizes and/or various turnover ratios.
Here’s the portfolio, at the close of trading on Friday, Feb. 28, 2020, showing the first five of 4,825 stocks that are, to some extent, selling for less than their 52-week highs:
Note that simply because a stock is selling below its 52-week high doesn’t mean it offers a margin of safety.
As you can see, the price-earnings ratios of some of these stocks are still quite high despite being well below their 52-week highs. The table also shows how many Gurus hold these stocks, which may be an indicator of quality (the more Gurus that own a stock, the greater the likelihood that it is a good investment in the long term). However, this should only be a starting point, and more due diligence would be required before buying any of them.
Conclusion
To answer the question posed in the title of this article, the U.S. markets are still overvalued, despite the dramatic drop that took place last week. We can say that with a relative degree of confidence, thanks to two GuruFocus tools.
The Shiller P/E is still well above its historic mean: 28.5 at the close of trading last week versus a historic mean of 17. At this level of valuation, investors who commit their money now could see an average loss of more than 1%.
The Buffett Indicator also sends the same message, estimating that the U.S. market is “Significantly Overvalued” and likely to produce losses of around 2.1%.
Still, even at overvalued levels, there may be some stocks selling at a discount. For the brave, or for those confident that last week was an aberration, the Aggregated Guru Portfolios may turn up some undervalued stocks. A couple of other GuruFocus screeners are also suited for finding stocks selling at discounts: the Undervalued Predictable screener and the Buffett-Munger screener.
Read more here:
- Global Value: Allocating Your Assets With a Value Mindset
- Global Value: Valuation Extremes and Buy-Sell Signals
- Global Value: CAPE Ratio Valuations at Home and Abroad
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