We aim to consolidate our stock market valuation analysis into a single quantifiable measure.
The above is an average of five separate percentile scores below.
We use z-scores to measure each indicator’s current position relative to past values. The result is expressed in standard deviations from the long-term average and as a percentile. We limited z-score calculations to the last fifty years of data to improve their relevance to current market conditions.
We then calculate an average z-score for the five readings and convert that to a percentile. Our current indication is that stocks are highly over-priced, ranking above the 97th percentile.
Stock market capitalization to GDP
First popularized by Warren Buffett, stock market capitalization/nominal GDP is commonly known as the “Buffett Indicator.” The June value of 2.6 has a z-score of 2.31 standard deviations, ranking 98.97% in quarterly readings since 1974.
S&P 500 Price-to-Sales
The Price-to-Sales ratio is based on quarterly reported sales for stocks in the S&P 500 index. The ratio ignores fluctuations in profit margins, which are assumed to revert to the mean over the business cycle. The June value of 2.86 has a z-score of 2.21 standard deviations, ranking 98.65% in quarterly readings since 2000.
Shiller CAPE
Robert Shiller introduced the Cyclically Adjusted Price-Earnings Ratio (CAPE) in his book Irrational Exuberance (2000). CAPE calculates the S&P 500’s price-earnings ratio based on average inflation-adjusted earnings over the previous ten years. The September PE of 36.83 has a z-score of 1.62 standard deviations, ranking 94.69% in monthly readings since 1974.
PE of Highest Trailing Earnings
We prefer to use a price-earnings ratio calculated against the highest preceding four consecutive quarters of earnings. This minimizes earnings volatility from the business cycle while avoiding moving averages, which are susceptible to the base effects of weak earnings at the bottom of the business cycle. The June value of 27.6 has a z-score of 1.91 standard deviations, ranking 97.0% in quarterly readings since 1974.
S&P 500 Forward PE
The forward-looking price-earnings ratio is based on S&P Global’s forecast earnings for the next four quarters. The June value of 23.3 has a z-score of 1.50 standard deviations, ranking 93.1% in quarterly readings since 1974.
Conclusion
Extreme overpricing of stocks tends to occur near the end of a bull market but is not particularly useful for market timing. As Keynes is reputed to have said, “Markets can remain irrational for longer than you or I can remain solvent.”
However, indications of stock market value are still useful when making decisions about risk, such as whether to commit new funds to the market or withdraw to the sidelines and wait for a better opportunity.
Acknowledgments
- S&P Global: S&P 500 Index Earnings
- Multpl.com: Shiller PE Ratio
- St Louis Fed, FRED Economic Data: Market Cap/GDP
