- The S&P 500 is trading at higher levels than peaks of 2000 and pre 2008 crisis while the NASDAQ is in touching distance of the dotcom bubble highs, leading to talks of overvalued markets.
- The valuation multiples are largely in line with the pre-2008 crisis levels. Also the Warren Buffett indicator points to a clear case of overvalued markets suggesting that the markets are at an extremely risky phase.
- In these risky markets, Investors will be better off putting their money into fundamentally strong stocks rather than momentum driven stocks.
The last few years have seen stock prices being driven by metrics other than earnings. Billion dollar valuations today are being driven by metrics like number of unique visitors without a second thought to revenue generation or earnings growth. WhatsApp, with no concrete revenue generation model, was acquired by Facebook for $19 billion, with an average value per WhatsApp user of $38. These are kind of deals which have fuelled talks of a technology bubble 2.0, following the dotcom bubble of the late 1990’s. Are we heading into a bubble or are these talks misplaced? We look at various indicators of overvalued markets to answer these questions.
Nasdaq and S&P 500 levels
|1999-00 peak||2007-08 peak||Current value||Change from 1999-2000||Change from 2007-2008|
The NASDAQ is still below the levels it traded in 1999-2000, highlighting the fact that we are still a short way off from the insanely risky levels of 1999-2000. However, given the repercussions technology stocks faced following the stock market crash in 1999, technology investors could lose sleep at the current NASDAQ levels too.
The March 2000 peak was followed by a 70% fall in NASDAQ over the next year and a half with Priceline (PCLN) losing 91%, Cisco (CSCO) losing 78% and Apple (AAPL) down by 84%. The correction that followed the peak of 2000 washed away investor wealth quicker than most realized. Hence talks of overvalued markets find a place among investors's at current market levels.
Looking at the S&P 500 levels, the index is well above the 2000 peak as well as the 2008 peak. Let's now take a look at the S&P 500 valuation ratios.
S&P 500 Valuation ratios
The table below summarizes the current valuation ratios of the S&P 500.
|Multiple||2000 peak||2007 peak||As of today|
|Shiller P/E ratio||43.77||27.55||26.21|
As reported on multpl.com
The S&P 500 PE ratio and shiller PE ratio multiples are lower than their pre 2008 crisis peaks, while being significantly lower than their 2000 levels. The high PS ratio of the S&P 500 shouldn’t be a cause of worry given the fact that today’s earnings multiples are significantly lower than their earlier levels. While earnings of the companies have certainly risen, PE ratio levels are closer to the 2008 levels and hence investors are justified in their fears of a correction.
The Warren Buffett indicator
While the current trading levels of the NASDAQ and S&P 500 suggest the markets are entering into an overheated territory, we also consider the the Market cap to GNP ratio, also known as the Warren Buffett indicator.
The Warren Buffett indicator compares the total Market cap (TMC) to gross national product (GNP) in order to understand the valuations levels of the markets. The Q2 2014 US GNP was reported as $16.18 trillion. According to the world federation of stock exchanges, the total market capitalization of stocks listed on US exchanges, at the end of August 2014 was $26.07. The S&P index has moved 1.1% lower from the end of August 2014. We adjust the Total market capitalization number for the S&P correction in the month of September, giving us a Total market capitalization of $25.78 trillion. According to our estimate, the current total Market Capitalization to GN ratio of US markets is 1.6.
According to Buffett, a ratio of 1 is an indication of modestly overvalued markets while a ratio of 2 indicates a highly overvalued and dangerous market. The TMC to GNP ratio of 1.6 is a case of significantly overvalued markets, far higher than the pre 2008 crisis level of 1.36.
The markets today are risky with the underside risk largely outweighing the potential upside. In these overvalued and risky markets, stocks trading in close relationship to fundamentals will most likely outperform the broader markets. Therefore, investors should look for low risk but stable stocks with fairly predictable profits and cash flows rather than betting their money on momentum stocks. Our top technology stock picks, based on fundamental strength are just some examples of fundamentally strong stocks.