As of Dec. 1, the U.S. stock market’s total market cap to gross domestic product is 123.5%, about a 5% increase from Nov. 4 valuations. Even though the overall stock market is overvalued, some sectors are relatively undervalued. Among the sectors, the energy sector has the lowest median Shiller price-earnings ratio, suggesting potential value-increasing opportunities.
Overall stock market overvalued according to Buffett and Shiller
Warren Buffett (Trades, Portfolio), CEO of Berkshire Hathaway Inc. (BRK.A, Financial) (BRK.B, Financial), measures the market valuation with “probably the best single measure of where valuations stand at any moment,” the TMC / GDP ratio. As illustrated in Figure 1, the Wilshire Total Market index currently stands at $23.042 trillion, about 123.5% higher than U.S. GDP. Buffett’s indicator implies an average annualized market return on -0.1%, including dividends.
Figure 1
The “Predicted and Actual Stock Market Returns” chart displays the expected returns in the optimistic case, the expected case and the pessimistic case. Based on Figure 2, the expected annualized market return can range from -8.0% to 4.3%.
Figure 2
Yale professor Robert Shiller offers an alternative market valuation based on a “price to adjusted earnings” ratio. Instead of simply using earnings per share, Shiller adjusts these earnings for inflation using the consumer price index. This adjustment corrects one major flaw of the standard P/E ratio: artificially low ratios during economic expansions and unreasonably high ratios during recessions.
Based on the current Shiller P/E ratio of 27.9, the U.S. stock market expects to return -1% per year, about 0.9% worse than the Buffett implied return. The Shiller P/E ratio exceeds the historical mean by 67.1%. Figure 3 graphs the historical trend of the market Shiller P/E ratio and the implied expected return.
Figure 3
Not all sectors are overvalued
As the U.S. stock market is rarely balanced, some sectors are relatively undervalued while other sectors are significantly overvalued. The following statistical study identifies the sectors that are undervalued compared to other sectors and the overall market. These sectors likely have higher value potential than the overvalued sectors.
Figure 4 illustrates the distribution of average median Shiller P/E ratios across industries for all companies trading on the New York Stock Exchange and the Nasdaq. The distribution is slightly left-skewed with a median near 35. Most industries have average median Shiller P/E ratios between 20 and 50.
Figure 4
To determine which industries offer the highest value potential, we must first determine how many companies in each industry trade below their median Shiller P/E valuation. For each company, we first compute the price at the median Shiller P/E and compare it to the current share price, and then assign an investment rating based on the relative valuation. As the overall stock market is significantly overvalued, most of the industry investment grades are negative. However, two industries from the energy sector have the highest investment grade: 57 for oil and gas E&P companies and 32 for energy equipment and services companies.
The blue bars in Figure 5 display the average median Shiller P/E ratios across industries for NYSE and Nasdaq companies while the green bars display the respective values for just the companies trading on the Standard & Poor’s 500 index. The red line shows the percent of undervalued companies for each of the sectors.
Figure 5
The “Shiller Energy” customized screener lists eight energy companies that trade below their median Shiller P/E valuations. FMC Technologies Inc. (FTI, Financial) likely has the highest value potential with a financial strength rank of 6, a profitability rank of 7 and a predictability rank of four stars. Other energy companies with a profitability rank of 7 include Core Laboratories NV (CLB, Financial), Cabot Oil & Gas Corp. (COG, Financial), EOG Resources Inc. (EOG, Financial) and National Oilwell Varco Inc. (NOV, Financial).
See also
As the stock market is significantly overvalued, there is high “recession risk.” Due to the high risk of recession, Buffett and Charlie Munger (Trades, Portfolio) suggest staying defensive and look for companies that meet their four-criterion approach. Such companies have at least a four-star predictability rank, sustainable competitive advantage, high profit margins and growth rates, and little or no debt. Additionally, these companies are undervalued based on their PEPG, the price-earnings ratio divided by the average five-year EBITDA growth rate.
One suggestion is to invest in Buffett-Munger companies trading in sectors with relatively low Shiller P/E ratios. Note that the red line in Figure 5 shows three peaks: consumer cyclical, consumer defensive and energy. The line also shows a slight peak at utilities. This suggests that these sectors offer the best value potential in a significantly overvalued market. As of Dec. 1, nine consumer cyclical and two consumer defensive companies made the Buffett-Munger screener.
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Disclosure: The author has no position in the stocks mentioned.
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