US Stock Valuations Reach a New High

Bull/Bear Market Indicator
Stock Market Pricing Indicator

The gauge on the left indicates bull or bear market status, and the one on the right reflects stock market valuation levels. Stock market pricing indicates whether stocks are cheap or expensive relative to earnings, but it is a poor indicator of market timing. We do not recommend selling stocks because the market valuation is high, but we would advise investors to be circumspect about adding new positions without careful investigation of the underlying value.

Bull/Bear Market

The Bull/Bear indicator remains at 40%, warning of a bear market ahead.

Bull-Bear Market Indicator

The Fed resumed rate cuts, with the fed funds target rate now 4.0% to 4.25%, and a mid-point of 4.125%. The downward cycle warns of a bear market.

Fed Funds Target Rate Mid-point

However, the Chicago Fed National Financial Conditions Index declined to -0.558, indicating loose monetary conditions that will likely support stock prices.

Chicago Fed National Financial Conditions Index

Stock Pricing

Stock pricing increased to a new high of 98.32 percent, compared to the April low of 95.04 percent. The extreme reading warns that stocks are at long-term risk of a significant drawdown.

Stock Market Value Indicator

We use z-scores to measure each indicator’s current position relative to its history, with the result expressed in standard deviations from the mean. We then calculate an average for the five readings and convert that to a percentile. The higher that stock market pricing is relative to its historical mean, the greater the risk of a sharp drawdown.

Warren Buffett’s favorite stock market valuation indicator, market capitalization climbed to a new all-time high of 2.84 times GDP in the second quarter, more than double the long-term average (since 1974) of 1.175.

Stock Market Capitalization/GDP

Conclusion

The bull-bear indicator at 40% warns of a bear market ahead, while extreme pricing increases the long-term risk of a significant drawdown.

Acknowledgments

Notes

Warren Buffett: Speculation v. Investment

Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.

~ Warren Buffett

Warren Buffett: Bonds and portfolio risk

It is a terrible mistake for investors with long-term horizons – among them, pension funds, college endowments and savings-minded individuals – to measure their investment ‘risk’ by their portfolio’s ratio of bonds to stocks. Often, high-grade bonds in an investment portfolio increase its risk.

~ Warren Buffett, letter to the shareholders of Berkshire Hathaway – February 24, 2018

America should stand for more than just wealth, says Warren Buffett

Judy Woodruff from PBS with Warren Buffett in a wide-ranging interview:

  • Why you should invest in America
  • Why health care in the US is sick and needs fixing
  • Why America should stand for more than just wealth

Buffett on Wells Fargo: “It was a terrible mistake. They incentivized bad behavior. Incentives work. But they work in either direction.”

Is the market overpriced? Episode II

Using Warren Buffett’s favorite broad market valuation metric of market capitalisation over GDP*, we can see valuations are on the high side, near to levels from early 2006, but nowhere near the alarming bubble of two years later. The Dotcom bubble (not shown) was even more severe.

NYSE Market Cap/Nominal GNP

*I have used GNP (or GNI as some call it) as this more accurately includes offshore income.

Australian investors will be relieved to find the ASX, at 100, reflects fair value. Even if we ignore the 2007 property/resources bubble.

ASX Market Cap/Nominal GNP