Last week the market continued to rise. Over the last quarter I began averaging in to Honeywell and even added on to my stake in Disney. Now I’m once again left scratching my head wondering what to buy next. The market appears overvalued, significantly so. The reason I don’t sell, however, is because we haven’t seen this kind of economic climate before. For instance, we have inflation below 2%, low interest rates in the U.S., negative rates in Europe, unemployment of around 3.7%, a weak industrial sector, and a very strong U.S. consumer. Other reasons for not selling include taxes and cash flow. I don’t want to pay a 15% tax on my gains, and I like the dividend checks these companies are producing.
Unfortunately, you never know when the market will crash. Usually, a market becomes overvalued and powers ahead until there is a negative catalyst. The question is, how expensive is the market really. Well, I found a couple of good indicators known as the Shiller P/E and the Wilshire GDP. The Shiller P/E or cyclically adjusted price-to-earnings ratio is a valuation metric applied to the S&P. It is calculated by dividing price by the 10-year average of earnings. The average Shiller P/E is 16.6. This number broke 30 on the eve of the 1929 crash, 45 before the dot-com bust, and 26 right before the Great Recession. Today it is approximately 30.54, indicating rich valuation.
Another metric we could point to is the Wilshire GDP. Also known as Market Cap to GDP or the Buffet Indicator; Wilshire GDP measures the sum of the market cap of all U.S. stocks relative to gross domestic product. This figure hit 161% in 2000 and close to 120% in 2008. Today it stands at 144%. Essentially, this metric is telling us U.S. stocks are significantly overvalued relative to our GDP. Optimally, we would like to see this number at 100% or less. Furthermore, we recently saw an inversion in the yield curve, which further predicts a major stock correction and/or recession. And finally, we’ve seen economic “softness” around the globe.
These measurements have had a good track record of predicting past stock market corrections. However, as I mentioned earlier, we are in an economic environment we’ve never seen before. In addition, businesses have changed dramatically over time, technology advanced, and business regulations are different. Median incomes are also up, and the investing is easier, technically speaking, than ever before. Therefore, low interest rates, a cash abundance, and the ease of investing has increased the demand for stocks. And finally, we don’t yet have a negative catalyst to drive markets lower. The conclusion we can reach from the data is there is significant risk in the market. However, given the unique time we live in, it still makes sense to have some exposure to U.S. equities.
DISCLAIMER: I am not a licensed investment adviser or tax professional. I am not liable for any losses incurred by any parties. This blog should be viewed for entertainment and/or educational purposes only. Any transactions published are not recommendations to buy or sell any securities. Please consult with an investment professional before making investment decisions.