Is the stock market overvalued? using the PE Schiller ratio

A follow-up to the article and video examining how interest rates affect the stock market, this article will delve deeper into the important question, “Is the stock market overvalued?”

You will learn about the tools used to assess whether a market is overvalued and the intricacies of market valuation.

Is the stock market overvalued?  Understanding the Shiller S&P PE Ratio.
Is the stock market overvalued? Understanding the Shiller S&P PE Ratio.

How to measure if the stock market is overvalued

Economists disagree about the best way to measure whether the stock market is overvalued. However, they agree that the Shiller PE ratio, a 10-year cyclically adjusted price earnings ratio (CAPE ratio) for the S&P 500, is a valuable contribution.

Here is a graph from 1860 to 2021 that compares US long-term interest rates to the Shiller Price Earnings Ratio for the S&P Composite. Interestingly, the correlation between long-term interest rates was at its lowest and stock prices were very high.

140 Year Chart: Is the Stock Market Overvalued?  Long-term interest rates vs. the Standard & Poor's interest rates.
140 Year Chart: Is the Stock Market Overvalued? Long Term Interest Rates vs. the Shiller S&P Rate Earnings Ratio.

The price-earnings ratio line shows that in terms of earnings, stock prices were very high in 1901, 1929, 1966 and 2000. We know that the stock market was overvalued at this point because the market went through a crash/collapse right after reaching this high levels.

Research shows that the stock market crash of 1929 and the DotCom crash of 2000 were caused by poor corporate risk management, which caused stock bubbles, which led to the stock market being overvalued.

So what can we learn from this?

If we see the Shiller CAPE PE ratio for the S&P composite rise above 35, then Stocks may be overpriced. Be very wary of an expensive market. The Shiller PE Ratio shows us how stocks are priced relative to their actual earnings. So a market PE of 20 means that based on the capital invested, these companies will take 20 years to pay back the investor. Or if we look at it another way, it means that the investor is willing to pay 20 times the company’s earnings for a stake in the company.

Is the stock market overvalued?

Leading economists and investors cannot agree on whether the stock market is currently overvalued. Economists claim that stocks are currently cheap compared to bonds, and allowing interest rates means that Treasuries and bonds are not profitable; So, this benefits the stock market.

Shiller S&P’s composite polyethylene ratio is now close to an all-time high. However, economists also argue that because the tech giants have risen and their near-monopoly yields huge profits, a high valuation does not imply a near crash anytime soon.

In addition, the political and economic balance of power in the past ten years has shifted toward capital, and the move away from labor can help explain the new normal in market valuations. In 2021, the earning season has never been so good; There is a lot of cheap money in the economy, and companies use it to make huge profits.

Video: Is the stock market overvalued?

Video from the Editorial Stock Trader Professional Course 2022

Should investors worry about a stock market crash?

The argument is that government stimulus and low interest rates are unaffordable, and it will lead to an equity bubble that will lead to a crash. But in “Detainees Theory of Fiscal Policy 2021,” economists argue that the United States and other countries still have plenty of room for debt. Governments that strike the right balance of debt and investment can drive economic development and improve the quality of life for their citizens. Today’s economists also point out that underdebt is also harmful, “when a very low level of debt triggers a serious deflation, dragging the growth rate into negative territory and below the interest rate.”

Is the stock market overvalued now?

Leading economists point out that the stock market is not overvalued at the moment. The combination of booming corporate earnings, government stimulus investments, and declining bond yields due to lower interest rates is positive for stocks. Although the Shiller CAPE ratio is currently historically high, the general belief is that times have changed, and governments have learned to manage risk better.

Live Chart: Are Stocks Overrated?

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With this interactive chart from TradingView, you can see the current Shiller PE ratio for the S&P Composite Index from 1914 to today. Historically, stocks seem expensive, but as discussed in this article, a lot has changed both economically and capital markets over the past 100 years.

How to assess if the stock market is overvalued.

With this interactive chart, you can compare the Shiller CAPE ratio to the actual performance of the S&P 500 Index.

  1. Click Compare.
  2. Type SPY in the search box and select SPDR S&P 500 ETF Trust.
  3. Select Settings (bottom right) and select Logarithmic Scale.
  4. Use the mouse wheel to zoom in and out of the chart.

Do you think the stock market is currently overvalued?

Live Chart: S&P 500 Dividend Yield

What happens when the stock market is overvalued?

If the stock market is overvalued, there are two possible outcomes. Initially, governments will try to manage the situation to ensure an orderly return to balance using prudent fiscal and monetary policy. However, if there is a rise in inflation, a financial shock, or government attacks on the corporate sector, it may change the balance and cause stocks to crash.

How to invest in the overvalued stock market?

Investing in the overvalued stock market involves a decision that only you can make. You can continue investing as stock markets can remain overvalued for a long time or diversify into other investments or funds.

1. Continuing to invest in the overvalued stock market.

Because the stock market default trend is rising, if you continue to invest, the market will eventually recover, and you will continue to make money. If you contribute regularly to your stock investment, you’ll be able to take advantage of the dollar cost average (DCA) to accumulate more shares at lower prices as the market goes down. This option allows you to continue investing without the need for market time.

This solution has its drawbacks, especially if you are about to retire and don’t have time to wait to recoup your losses. This brings us to the second option.

2. Diversify your investments in other assets.

Market timing is not for the faint of heart, and the vast majority of people get it wrong. Another problem is that other asset classes do not produce good returns; In 2021, real bond yields are actually negative. All over the western world, we are starting to charge negative interest on the cash in our bank accounts.

There are technical systems to help you judge whether it is the right time to take money on your investments and move to cash. The stock market crash detector I developed is one such system, and I think it’s good, but no system is fool-proof. I have also developed a Free Stock Market Fear and Greed Indicator to help you determine if the market is in greed mode (bullish market) or fear mode (bear market).

But as The Economist says, “If there are reliable trading signals, everyone will follow them. And then there will be no one to sell to at the top and no one to buy from at the bottom.”

You want to be a successful stock investor but don’t know where to start.

Learning to invest in the stock market on your own can be overwhelming. There is so much information out there, it’s hard to tell what’s true and what’s not.
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