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July
28
2023

Stocks: Undervalued or Overvalued?
Brian Maher

The stock market has been up and away this year.

Rather, a relative handful of technology stocks have been up and away this year.

The major indexes are hitched to these wagon-pullers… and that is largely why these indexes have excelled this year.

Today the draft horses took to slacking — and slid a bit downhill.

The Dow Jones Industrial Average went 237 points backward today.

Honeywell exerted a strong negative pull on the index, down 4% on the day. It provided too much drag to overcome. The burden proved too heavy.

Thus the index ends its 13-day win streak — its longest win streak since 1987.

1987!

The S&P 500 retreated 29 points today, the Nasdaq Composite, 77 points.

Perhaps it is a simple case of fatigue, argues Mr. Jonathan Krinsky of BTIG:

As has been the case for the last couple of weeks, there are signals the rally should be getting tired.

Gold, incidentally, took to panicked flight today— down $26 and change.

Yet the daily flittings of the stock market do not concern us. Cast today’s results aside…

A question presents itself: Are stocks undervalued, justly valued or overvalued?

Today we go in search of answers, in search of light.

The Buffett Indicator

Shall we first consider Mr. Warren Buffett’s famous indicator?

The Buffett Indicator is simply the ratio of total United States stock market capitalization to the gross domestic product.

A reading below 1 indicates a stock market undervalued against the economy underlying it. Stocks are bargains.

A reading of “1” indicates a stock market and economy marching in step, neatly in formation.

A reading above 1 indicates a stock market overvalued against the economy underlying it. Stocks are dear, costly.

This gauge read 2.1 prior to the 2000-01 collapse with its horrific overvaluations in the technology sector.

That is, total stock market capitalization registered 2.1 times GDP.

The Buffett indicator attained a delirious 2.6 in late 2021 — a record.

What is its present reading?

1.8.

That is, the stock market is substantially overvalued relative to the gross domestic product.

The gross domestic product hovers at $26.74 trillion. Total stock market capitalization, meantime, runs to $48.37 trillion.

A 1.8 ratio does not represent a 2.1 or 2.6 lunatic derangement, it is true.

It nonetheless represents an overvalued stock market — in Mr. Buffett’s telling at least.

Of course this Buffett indicator is no crystal sphere. It yields neither day nor hour of a bubble-burst.

It merely takes the overall view. And the overall view is overvaluation — again, in Mr. Buffett’s telling.

Let us next consider the Shiller P/E ratio…

Bubble Territory?

What is the Shiller P/E ratio? It is simply another implement crafted to determine the valuation of stocks.

Analyst William Bengen:

This metric represents a P/E for all the companies in the S&P 500, based on their current stock prices and the previous 10 years of inflation-adjusted earnings. It seeks to “smooth out” short-term fluctuations in earnings and come up with a P/E representative of the true earning power of the companies involved.

As history goes, a 17 reading is about par.

On 1929’s Black Tuesday this ration measured 30. In December 1999 the ratio posted a record 44.19 reading.

But again, a 17 ratio is about par as history runs.

What is today’s ratio, you ask?

The answer is 31.6 —  14 points above historical par — but 13 points beneath peak delirium.

That is, stocks are substantially overvalued but not obscenely and preposterously overrated.

What are we to make of it? We do not know.

As the Buffett indicator, Mr. Shiller’s ratio wields limited predictive power.

It gives the climate — not the weather.

Fair winds and fair skies may prevail for months and months. Or heavy weather can come barreling in tomorrow, from a clear sky.

The “Fear and Greed” Index

Meantime, CNN’s “Fear and Greed” Index gauges investor sentiment.

A reading below 25 indicates investors are extremely fearful. A reading between 25 and 50 indicates they are merely fearful.

A reading between 50 and 75 indicates investors are greedy while a reading between 75 and 100 indicates investors are extremely greedy.

What is the present reading?

78 — investors have crossed into extreme greed.

What do we do when investor greed attains extreme heights?

We take to our heels… and flee.

For when the crowd is extremely greedy we are extremely fearful.

It informs us that a “correction” of some magnitude is likely in prospect.

Affirms Investing.com:

The stock market community should at least be cautious, as the current level of the sentiment index could be a harbinger of an impending stock market correction that has the potential to shake the U.S. stock indices, at least in the short term…

What exactly does it mean when the Fear & Greed Index moves so persistently in the direction of “extreme greed”? Well, it is a clear sign that overheating is imminent. When greed overpowers reason and investors become blinded by greed, they are at risk of falling into a trap.

Prices rise and rise, but eventually, the day comes when reality catches up with them and the markets are corrected forcefully. This correction can lead to a sharp decline in stock prices and force investors to freeze their gains or even accept losses.

Historically, “extreme greed” has often had dire consequences and is considered a harbinger of a stock market correction.

The Only Way Fools Learn

Again, we issue no prophesy of impending correction — or worse. We merely appraise conditions as they exist.

Yet we believe powerfully in one fundamental concept — “reversion to mean” — and the punishing laws of probability.

As we have noted before: Scales ultimately balance even and extremes iron out. The great equalizer of time does the ironing out.

That which goes up comes down, that which goes down comes up. Mountains rise, mountains crumble, the meek finally inherit the Earth.

Extremes do not endure.

Yet the fools are rushing in, as they so often and predictably do at such times as these.

We hazard they will come to grief, soon or late.

“Experience runs a hard school,” said old Ben Franklin… “but fools will learn in no other.”

 

 

Brian Maher is the Daily Reckoning’s Managing Editor. Before signing on to Agora Financial, he was an independent researcher and writer who covered economics, politics and international affairs. His work has appeared in the Asia Times and other news outlets around the world. He holds a Master’s degree in Defense & Strategic Studies.

 

 

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