Due in large part to actions by the Federal Reserve and the lack of good investment alternatives, the stock market may be in the midst of one of the greatest bull markets of all time. With interest rates on cash at record lows and much of the bond market will likely suffer losses when interest rates rise, many are hoping the bull market in stocks will continue a while longer. However, as investors know all-too-well, bull markets eventually end and are followed by bear markets. No one wants to get caught holding a large allocation of stocks when the bottom falls out. In this article, we’ll look at where stocks are from a valuation point of view and discuss what investors should be doing to prepare.
Let’s begin with a primer on stock valuation. If the price per share on a specific stock is $20 and its fair value is $30, the stock would be considered undervalued so it may be prudent to invest in it. Conversely, if its price is $20 but the valuation suggests $15, the stock would be considered overvalued and it may be wise to sell it. Obviously, stock valuation is an integral part of investing. There are a number of ways to determine the proper valuation of an individual stock or the entire market. For our purpose, we’ll confine our discussion to one particular valuation methodology known as total stock market cap to GDP. This method also happens to be Warren Buffett’s favorite. Here’s how it works.
The premise of this methodology is based on the notion that stock prices and the economy have a symbiotic relationship. In other words, stock prices are dependent on profits and profits are more easily attained when the economy is growing. A strong economy is a reflection that consumers and businesses are spending and the velocity of money is increasing. As profits increase, stock prices tend to rise. To further explain how this valuation methodology works, consider the following example.
Let’s assume you own a publicly-traded company that has issued a total of 2 million shares. Further assume that you, as owner, own 1 million shares and the other million are owned by investors. Thus, there are 1 million shares outstanding. If the price per share was $20.00, then the total market cap of your company’s outstanding shares would be $20 million (1 million shares X $20 per share). The total stock market cap to GDP valuation ratio compares the total market cap of all U.S. shares outstanding to GDP. For example, if the total market cap was $16 trillion and GDP was exactly the same, the ratio would be 100% ($16 trillion market cap / $16 trillion GDP). Many times stocks get ahead of the economy and total market cap rises faster than GDP. For example, if total stock market cap was $18 trillion and GDP was $16 trillion, the ratio would be 112.5% and stocks would be considered overvalued. Let’s look at the following chart to demonstrate how this works.
Notice where I have marked the Tech Bubble. This is the point where the ratio hit its all-time high in March 2000, just prior to the bursting of the bubble. It reached a level of just over 146% at that time. When the housing bubble burst, the ratio was only around 108%. Remember, this was not a stock bubble, it was a housing bubble which caused stock prices to collapse. Today the ratio is 126.8%, which is between the Tech and Housing bubble readings. This does indicate that stocks are overvalued.
It should be noted that the horizontal red line is at 100%, which is the point where the U.S. stock market is fairly valued. Again, this means total stock market capitalization is equal to total GDP. Back to the present reading, while it is true that U.S. stocks are currently overvalued, that doesn’t mean stocks are going to decline. It only indicates that stocks are presently overvalued. The question is at what point will stock prices fall? Perhaps more importantly, what will cause the next stock correction?
What Will Cause The Next Stock Market Correction?
One reason for the current and prolonged bull market is the lack of good alternatives. Remember cash is paying very little and bond prices are highly susceptible to rising interest rates. What could cause the next correction? In the absence of a natural disaster or a terrorist attack, meaning under normal circumstances, stock prices may continue to rise until investors find a suitable alternative. We are now in the seventh year of the current stock bull market. The average length of time for a bull market is approximately 5.5 years. At this point, the potential reward for stocks is low because stocks have been trending higher for such a long time and the risk is high for the same reason. We know that everyday stock prices rise we are one day closer to the next downturn. What we don’t know is when this will occur. Perhaps the most likely catalyst for a correction in stocks is rising interest rates. When interest rates reach a certain level, we could see a mass exodus from stocks, into bonds, and the current bull market will come to a screeching halt. The longer this bull persists, when the correction comes – and it certainly will – it may be more severe than 2008.
Because of these and other reasons not mentioned, the Fed through monetary policy and the government through fiscal policy, are largely responsible for the current climate and the coming collapse. These are indeed extraordinary times. Stocks are definitely overvalued, but because there is a lack of good alternatives, the run up could persist a bit longer which of course makes the next down turn all the more severe. In the interim, it would be wise to invest with caution and keep an eye out for signs of the next crisis. Stocks are already overvalued. If this becomes even more elevated, as I believe it will, the decline is likely to be more severe. After all, the next correction is not a question of if but when.
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