How to Spot Market Tops: Valuation Metrics

May 4, 2017 | Securities

Market Tops can be predicted

In previous articles, we discussed several ways to identify market tops. We already covered macroeconomic indicators and interest rate cycles. Here we will analyse valuation metrics and see what they tell us about the current stock market. Markets usually peak when there are significant signs of overvaluation.

1. Total market cap relative to GDP

If we look at the market value of all the stocks traded in the US and compare it to nominal GDP levels, it might give us an idea of how far stock prices are from the “real economy”.

Source: Federal Reserve Bank of St. Louis

We see that, in the first quarter of 2017, US stocks were trading at almost 1.5 times the value of US GDP. At first glance, it might seem that stocks are terribly overvalued, as they have been trading at all-time highs relative to GDP for the past 2 quarters. However, there have been important structural changes in the economy in recent years, so we need to look at other metrics to get a better sense of market value.

For example, in the past 20 years companies have reported significantly higher profits relative to GDP, which might justify current valuations. Therefore, we also need to compare prices with earnings.

2. Price-to-Earnings (P/E) and Price-to-Earnings-to-Growth (PEG)

If we look at trailing price/earnings (current stock prices vs past earnings), we see that the current market is trading close to the average value of the past 20 years. Therefore, according to this metric, the current market is not overvalued and in fact seems to be fairly valued.

Source: Jeremy Grantham, Barron’s 2017

This increase in the average P/E since 1996 reflects the structural changes in the economy over the past two decades. We see this in corporate profits, which have also jumped from 3.8% of GDP to 4.5%, on average.

Source: Jeremy Grantham, Barron’s 2017

Another way to check if the market is overvalued is to look at forward price/earnings (current prices vs expected future earnings). While forward P/E values have been rising since 2011, at 17.4 they are still far from the highs of 1999.

Source: Yardeni May 3, 2017

The PEG ratio, which measures P/E against predicted earnings growth, is another forward-looking way to assess market valuation. We see that, at 1.4, it is above the average of the past 20 years but remains within acceptable levels.

Overall, when we compare stock prices to earnings and earnings growth, we see that the market appears to be close to a fair valuation.

3. Stock prices vs Bond prices

Another important way to check if the market is overvalued is to look at bond prices and interest rates. One of the main structural changes in the economy over the past 20 years was how interest rates have remained at persistently low levels. Both the federal funds rate and the 10-year US Treasury bond rate are close to record lows.

Source: Federal Reserve Bank of St. Louis

This is important for the stock market because bond yields (their nominal interest rates) and stock yields (earnings over prices, the inverse of P/E) tend to move close to each other. The comparison between the two is often called the “Fed model”. In general, it tells us that lower bond yields should allow for higher stock prices.

Using this tool, we see that stock prices are actually undervalued relative to both government bond yields and corporate bond yields.

Source: Yardeni May 3, 2017

Overall, according to these indicators stocks seem to be close to fair valuation, which means that the current bull market still has some room for expansion.

<a href="https://ugc.net.au/author/joel/" target="_self">Joel Hewish</a>

Joel Hewish

Joel is the founder and CEO of UGC. He is a licensed financial advisor with 15 years experience assisting clients grow, manage and protect their wealth.

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