Is the Stock Market Overvalued?

Yes. So why is it rising to record-breaking levels?
July 24, 2019 Updated: July 24, 2019

Ask Warren Buffett and he’ll tell you that the best way to determine if the stock market is overvalued is the ratio of total market capitalization to gross domestic product. A ratio between 75 percent and 90 percent indicates that the market is fairly valued. Between 90 percent and 115 percent, the market is considered to be “modestly over-valued.” Any ratio over 115 percent means the market is “significantly over-valued.”

As of July 22, 2019, the total market capitalization to gross domestic product ratio is at 146 percent. At this extremely high ratio, average market returns over the next 7-10 years are projected to be negative 1.90 percent per year. That doesn’t sound like a good place to invest, does it?

To be fair, however, even the Guru of Omaha gets it wrong sometimes. Other experts’ estimates, for example. are even worse. Some expect returns to be as low as -9.70 percent per year over the next decade. But there’s no consensus on the matter. Some estimates are more optimistic.

Jack Bogle, founder of Vanguard mutual funds and inventor of the index fund, said in his one of his last interviews before he passed that he expected market returns for the next decade to be around 5 percent. That’s well off the 10-12 percent returns of the past decade, but certainly much more optimistic than more bearish observers.

But does an overvalued stock market mean we’ll see a market correction soon? Perhaps, but not necessarily. There are conflicting factors that come into play.

Never Bet Against the Fed

One huge factor is the Federal Reserve. There’s an old saying in the investment world that goes, “never bet against the Fed.” That simply means that the Fed’s monetary policy has overriding influence on the stock market.

For example, if the Federal Reserve’s policy is to raise short term interest rates, it usually does so to curb inflation. In that instance, the market and the economy will both likely follow a downward trend. That’s because rate hikes often trigger a pullback in economic activity or even a recession.

But if the Fed cuts interest rates – most expect another cut or two this year – more money will be available for investment. That includes the stock market. Lower borrowing costs give incentives for companies to expand. That expectation, however, may already be priced into the record highs we’re seeing in the market.

Corporate Profits to Fall

Another major factor impacting the market is corporate profits. They’re usually a significant and fundamental driver of rising stock prices, but not this year. The 2019 stock market run has happened despite corporate profit forecasts falling and NOT going up. The S&P 500 Index, a benchmark for the stock market, is trading at a price more than 17 times projected earnings, well above its ten-year average of 14.9 percent price-to-earnings (P/E) ratio. The last time the P/E ratio was that high was in late 2018, the S&P 500 fell about 5 percent for the year, and as much as 15 percent off of its all-time high.

What about rising consumer debt levels? Consumer debt has recently hit $14 trillion, higher than the $13 trillion in consumer debt when the Great Recession hit in 2008. That includes auto loans, mortgages, and credit card debt. This should be a harbinger of an economic slowdown, with typically means a market adjustment. But not yet.

Manufacturing Falling with Rising Dollar

Normally, the manufacturing sector is also a factor of asset prices because it’s indicative of economic activity. But as of the end of June, it has declined for two consecutive quarters, falling 1.9 percent in the first quarter and 2.2 percent in the second. This is the reason why an interest rate cut, or two, by the Federal Reserve is expected this year.

This negative trend indicates U.S. manufacturing is in recession even though some sectors within the manufacturing index, such as mining, business equipment, and construction were up. The trade war with China is viewed by many as at least a partial reason for the overall decline.

The growing strength of the dollar relative to other currencies is also partly to blame for the slowdown in manufacturing.

And yet, the market continues to rise. Currently, the S&P 500 is 4.8 percent above its 125-day moving average, and stocks reaching 52-week highs outnumber those hitting new lows. What’s more, volatility – an indicator of market risk – is neutral.

Why?

Corporate Buybacks Surging

One considerable factor is the record level and pacing of corporations buying back their own stock. They’re doing so for one very powerful reason – it delivers the highest return for shareholders.

In 2018, over $1 trillion in stock buybacks were announced, and this year’s announced buybacks looks like it will eclipse those of last year. Perhaps just as important as the amount is the rate of completion of the buybacks. Of the top 300 announced buybacks last year, more than 67 percent of the $1 trillion has already been bought. Corporate buybacks typically occur over the span of several years.

 Low Trading Volume Magnifies Impact of Buybacks

Ordinarily, stock buybacks would have only a marginal impact on stock prices. But in a low volume trading environment like the one we’re in now – typical of the summer months – the impact of buybacks is magnified.

This is especially true given corporations can buy up to 25 percent of the average daily volume of their stock.  Record levels of buyback activity combined with unusually low trading volume and being able to buy 25 percent of daily stock trading volume definitely gives corporations more influence over their stock prices than normal. It reduces the influence of short sellers as well. Stock price inflation is the result.

A Trend Reversal on the Horizon?

How should one regard the current market environment? It depends on how you look at it. The usual signs that point to a market correction are there. But those indicators can improve, too.

Viewed from a relative perspective, a strong argument can be made that compared to the rest of the world, even with our rising national debt and sharp political divisions, the United States is a better place to invest than most other places.

James Gorrie is a writer based in Texas. He is the author of “The China Crisis.”

Views expressed in this article are the opinions of the author and do not necessarily reflect the views of The Epoch Times.

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