Seven metrics that show the U.S. stock market is overvalued

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George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, University of Western Ontario.

Value investors are "economy agnostics."

The credit crisis of 2008, however, changed many value investors' view of the macro picture. They have come to realize that while the stocks they buy can be cheap, they can become even cheaper if the whole market is overvalued.

Is the market overvalued right now? Or worse, is there a stock market bubble?

It is possible. Artificially low interest rates can create bubbles.

Here are some ominous signs: U.S. companies have steadily increased their debt exposure over the last 15 years from about 175 per cent of GDP to around 240 per cent recently. Low interest rates have encouraged companies to raise debt to support mergers and acquisitions or for share buy backs. The market for M&A activity will hit a new record this year given that up to October there were deals completed worth $2.2-trillion. The previous cyclical peak was in 2007 when deals worth $2-trillion had been completed. Similarly, companies spent $650-billion this year in share buy backs, a new record exceeding the previous record of $566-billion reached in 2007.

How about some popular metrics of market valuation?

First, the ratio of Wilshire Total Market Index to US GDP, Warren Buffett's favourite, shows that the market is overvalued by 44 per cent. The ratio currently stands at 119 per cent versus a historical average of 82.5 per cent.

Second, the relative valuation of the equity market in relation to the bond market shows that the stock market is undervalued in relation to the bond market by 22 per cent. The earnings yield (the inverse of the PE ratio) exceeds the bond yield by 360 basis points. The long-term average is 280 basis points.

Third, the price to forward earnings ratio shows that the market is overvalued by 8 per cent. This ratio currently stands at 16.8 times vs. its historical average of 15.5 per cent.

Fourth, the cyclically adjusted price to earnings ratio (CAPE) that Nobel Prize winner Bob Shiller has developed, which uses the 10-year smoothed, inflation adjusted earnings, shows that the market is overvalued by 52 per cent. The ratio currently stands at 25.2 times versus a historic average of 16.6 times.

Fifth, the price to book value ratio shows that the market is overvalued by 17 per cent. This ratio currently stands at 2.8 times vs a historical average of 2.4 times.

Sixth, price to cash flow ratio shows that the market is overvalued by 6 per cent. This ratio stands at 12.5 times vs a historical average of 11.8 per cent since 2000.

Finally, the ratio of annual forward dividend to price (dividend yield) shows that the market is overvalued by 48 per cent. This metric currently stands at 2.10 per cent vs. a historical average of 3.1 per cent. This is calculated as dividend divided by price. So the higher the price, the lower the ratio and the greater the market is overvalued.

The above metrics indicate the U.S. stock market is overvalued by between 6 per cent and 52 per cent. Only one metric indicates undervaluation, but this measure is biased by the prevailing artificially low bond yields.

So is the market in bubble territory?

To answer this question, one needs to understand the drivers of the above ratios, which are interest rates and earnings growth. For example, CAPE of 25.2, which indicates the most market overvaluation, is not terribly high given the current interest rate and economic environment, and hence is not pointing to overvaluation, assuming earnings growth rate going forward remains at its long-term historical average of 7.4 per cent, and interest rates remain at the current all-time low levels. If, on the other hand, an investor believes that we are heading into a period of higher interest rates and lower earnings growth, then CAPE is indeed signalling overvaluation and, quite possibly, a bubble.

There are two facts to consider to this end. First, corporate profits, which had benefited in the past 7 years because of declining commodity prices and a weak jobs market, are now facing the risk of an "earnings recession" for the first time since 2008. The strong US dollar and the collapse of oil prices are partly to blame, but the tightening of the labour market compounds the threat on profit margins. Second, the current environment of rock bottom interest rates leads to the conclusion that there is an increased chance of higher interest rates going forward.

Normally, it is difficult to determine whether a bubble exists until it is too late. But even if we know we are in a bubble, it is difficult to foresee when it will burst. As a result, stay invested if you wish, but do what a value investor like Prem Watsa would do, namely, hedge the macro risk using, for example, long dated index put options.