I have written on multiple occasions about the US stock market overvaluation. Stock prices are high, too high, according to my analysis. The fact that the US stock market is overvalued is not a thing of the recent past. The US stock market has been overvalued for years. I had some fierce debates with other analysts who tried to prove me wrong. One of their often-repeated claims is that the US stock market is made up of a large share of technology companies, which tend to grow at a faster rate than companies from other sectors. In the past, the major US stock market indices largely consisted of companies from other sectors, such as utilities. Therefore, a higher price/earnings (P/E) ratio for the US stock market in recent times (compared to in the past) is justified. And moreover, the higher P/E ratio for the US stock market relative to other foreign stock markets is justified as well. Is there any truth to these claims?
For example, I wrote here, here and here on how various valuation metrics point at the fact that the (US) stock market is heavily overvalued. I tend to resort to the Equity Q Ratio. I briefly described the Equity Q Ratio as “how many euro’s [or dollars in this case] investors are willing to pay for every euro of net worth [of the underlying company].”
Usually, investors are inclined to favor the P/E ratio of the index over the Equity Q Ratio, perhaps out of a lack of awareness of what the advantages of Equity Q are. The P/E ratio can be obtained by simply dividing the stock price (or stock prices in plural when we refer to a market- or index-average) by the profit or profits.
The question that then is normally asked is: what profit or profits? We could take the profits of the past twelve months, but we could also use the average annual profits of the past ten years. The advantage of the latter is that the generally very volatile corporate profits are somewhat smoothed out. As a result, we are better able to isolate the effect of the “prices” whilst being less distracted by the “earnings” in the P/E equation.
In sum, the 10-year P/E ratio is, besides the earlier mentioned Equity Q, a rather robust indicator of stock market overvaluation. This specific P/E ratio is also known as “Shiller’s P/E ratio” (named after Nobel prize winner Robert J. Shiller), P/E 10, “Cyclically adjusted P/E ratio” or simply “CAPE.” Now observe the following chart:
In the above chart, we can observe that according to the 10-year P/E ratio, the stock market is extremely overvalued relative to the (historical) average P/E ratio for the S&P 500, one of the major stock market indices in the US.
But the Sector Composition Changes Over Time: Technology Companies Now Have a Greater Weight in the Index!
You might have seen the often-heard FANG acronym: Facebook, Amazon, Netflix and Google (which is now traded as its holding company Alphabet). These companies have, over the past years – in the midst of a bubble – shown extraordinary returns. In the current calendar year, these companies have returned on average 41.6% year to date, with another month to year end. Compared to the 14.1% that the S&P 500 returned so far this year, it is clear that technology companies are taking the lead and are outperforming other industries. It even led me to label the current bubble partially as “dotcom 2.0”.
Yet, apparently, we live in a “new economy.” New economic laws apply. The internet revolution is just getting up to speed. And my thesis on the “extreme overvaluation on the US stock market” is without foundation, according to critics.
The composition of the index has, after all, changed substantially over time. And at first glance, the ones that argue that the stock market is NOT overvalued have a sound argument. It is true: over the past years and decades, the sector composition of the index has changed significantly. Nowadays, technology companies have a greater share in the total index; in the past utilities, for example, had a greater share in the total index than now.
“Thesis proven!”, or many deniers of a renewed stock market bubble might be inclined to think.
Thankfully, GMO, the asset manager of the well-known investor Jeremy Grantham, has done the dirty work in a contribution which is titled "FAANG SCHMAANG: Don’t Blame the Overvaluation of the S&P on Information Technology."
The authors of this article figured that a crucial step was missing in the reasoning of these stock market cheerleaders: let us assume that these critics (investors who swear that there is no stock market bubble) are right and that the recent changes in the composition of the index proves us wrong. If that is true, then we have to correct the current P/E ratio for the modern sector composition and then see whether or not the P/E ratio still indicates a stock market bubble (that is, extreme overvaluation).
Let us take a close look at the conclusions of GMO, because then we can dispel for once and for all the myth that the US stock market is not by any stretch overvalued.
Let us begin with the first conclusion of the GMO analysis. If we compare the current P/E ratio (blue line, in broad strokes similar to the 10-year Shiller P/E) with the historical median P/E (red line), then we can observe that the US stock market is currently by 46% overvalued.
But as our critics pointed out, this ignores the fact that nowadays the sector composition is fundamentally different: the technology sector, for instance, has a greater weight in the index. Therefore, the gentlemen of GMO decided to correct the historical median P/E for sector composition. What is the median P/E ratio if we act as if the weight of every sector has always been equal to today’s?
GMO’s result is stunning: the stock market remains heavily overvalued, albeit a little bit less. If we account for sector composition, the US stock market continues to be overvalued by a staggering 39%. The historical median P/E ratio corrected for sector composition is 19.6, a bit higher than the 18.7 which was not corrected for the fact that sector weights changed over time.
Moreover, if the thesis of our critics is correct, then we should be able to observe that almost none of the individual sectors is overvalued. After all, according tot hem, the stock market index only appears to have a higher P/E ratio, but are we being tricked by the fact that certain sectors such as technology nowadays have a greater weight in the index than before. Technology stocks are historically not overvalued, they say, but technology stocks nowadays comprise a larger share of the total index.Thus, let us take a look at the average P/E ratio per sector or industry. Below you can observe the chart, again courtesy of GMO:
The conclusion should be clear: every sector is overvalued relative to its historical median sector P/E. For instance, the historical overvaluation of the financials could be surprising, but also the industrials and utilities stand out. Only energy and consumer staples are close to “fair value,” but even these problem sectors are still above their historical median P/E’s. In sum, the data on sector level clearly proves that the US stock market is heavily overvalued across the board.
And lastly, let us compare the other Western stock market (in this case by using the MSCI EAFE index) with the US stock market. The other Western stock markets have, of course, less technology stocks in their indices. Also observe the following chart which compares the sector P/E’s of the S&P 500 with its foreign peers:
Ironically, technology companies outside the US are actually even more extremely overvalued than their peers that are listed on the US stock market. But in all the other sectors, the companies listed on the US stock market are more heavily overvalued than their foreign peers.
In sum, even if we do not look at historical valuation (or P/E) levels, but only at the differences between the US and other foreign (Western) stock markets, we logically arrive at the conclusion that the US stock market is expensive, very expensive.
The US stock market is extremely overvalued, period. That does not help us determine when the next stock market crash might occur, but it does help us in showing that investing in (US) stocks is currently a stupid thing to do. The expected returns are for the coming years, if we take our cues from the past, low to extremely negative. The conclusion should be clear: avoid the US stock market at all cost.