Stocks have been on an uphill march since we began to exit the financial crisis of 2008–09. Massive monetary and fiscal intrusion into the market was thought needed to blunt the crisis, and even more when the pandemic hit in early 2020. Trillions of dollars buoyed asset values from cars to homes and from stocks to cryptocurrency. Anyone participating in these investments was making a lot of money—and still is today. But will it continue? Or are we going to finally get back to cyclical economic history and see stocks take a great fall?
The first step is to define what is a “good” (stock) price-to-earnings (P/E) ratio for investment purposes. There are different cuts and views that provide more insight than only an aggregate calculation might provide, such as:
- industry P/E average
- index P/E average
- company’s P/E average
- the top three closest competitor’s P/E average
Warren Buffet
The Buffett indicator is a widely used measure for assessing overall valuation of the stock market. It compares the total market capitalization of the U.S. stock market to our gross domestic product (GDP). For the United States, the Buffett indicator is calculated by dividing the Wilshire 5000 index—a broad market proxy—into the stock market valuation. The most recent Bureau of Economic Analysis estimate of the 2024 U.S. GDP is approximately $29.24 trillion, up 1.6 percent from last year.Comparing the value of the stock market to the value of the economy underlying the stock market, the Buffett indicator is like a P/E ratio. Buffett developed the indicator during the aftermath of the 1990s internet bubble that ultimately burst. This was a period when tech stocks had been driven by dot-com hype, as their stock prices pumped up valuations higher and higher relative to actual economic activity. They finally crashed in the early 2000s. Warren Buffett said that the ratio was “probably the best single measure of where valuations stand in any given moment.”
The Buffett indicator oscillates around the mean of 100 percent over the long run. The mean can be viewed as the benchmark for whether the market appears over or undervalued, reflecting either exuberance or pessimism to varying degrees. Market cycles demonstrate peaks and troughs around the mean, signaling investors when market valuations may be deemed relatively high or low.
Historical Highs:
- 1972: 81.1 percent
- 2000: 136.9 percent
- 2007: 105.2 percent
- February 2021: 172.1 percent
Historical Lows:
- 1982: 34.6 percent
- 1982: 32.2 percent (another low in the same year)
- 2002: 72.9 percent
- 2009: 56.8 percent
Source: Courtesy of Rodd Mann
Shiller P/E Ratio
Named after economist Robert Shiller, the cyclically adjusted price-to-earnings ratio (CAPE) adjusts for inflation and cyclicality by taking the average earnings over a 10-year period. Comparing CAPE to the standard P/E, the Shiller P/E is more stable, and can provide a much clearer long-term view in terms of market valuation. Note that the Buffett indicator uses the broader Wilshire 5000 Index while the Shiller P/E ratio is based on the benchmark S&P 500 Index.The Shiller P/E ratio as of Nov. 13 was 38.18.
- Mean: 17.17
- Median: 16.00
- Minimum: 4.78 (December 1920)
- Maximum: 44.19 (December 1999)
Concentration
The U.S. stock market has become concentrated—only a handful of stocks are driving a large percentage of the market’s gain, more so than at any time since the 1970s. The last two periods of high market concentration ended in a recession and a bursting valuation bubble. The market has become even more concentrated than it was during the early 2000s dot-com stock bubble, as a small number of stocks have driven most of the gains for the broadly based S&P 500. The top 10 stocks by market cap account for approximately 37 percent of the overall equities market as of Nov. 14.
High stock market concentration is risky for the following reasons:
- When a few companies dominate, negative news or adverse performance can lead to significant market downturns.
- A highly concentrated market runs counter to the benefits of diversification. Diversification spreads risk across many sectors and companies. When the market is concentrated, the performance of just a few companies has a disproportionate impact, increasing overall portfolio risk. Today, an otherwise less risky investment, such as an S&P 500 index fund, has become far more risky given concentration.
- Top companies are from the same sector (technology). This increases the so-called sector-specific risk. If that sector faces new regulations (anti-monopoly, for example) or other disruption, the drop will disproportionately affect the market.
- High concentration can lead to inflated valuations of these dominant companies. This creates a bubble, where stock prices are driven up well beyond their true value.
Source: Capital Group, Morningstar, MSCI, Standard & Poor’s. As of Aug. 31, 2024. Weights are shown by issue and are the sum of the top 10 holdings of each index on a monthly basis.
Summary
Understanding these risks is crucial for making informed investment decisions. Diversifying your portfolio and keeping an eye on market trends can help mitigate these risks. It’s time to lighten up on stocks and consider bonds, money market funds, or other alternative investment diversification strategies.The Epoch Times copyright © 2024. The views and opinions expressed are those of the authors. They are meant for general informational purposes only and should not be construed or interpreted as a recommendation or solicitation. The Epoch Times does not provide investment, tax, legal, financial planning, estate planning, or any other personal finance advice. The Epoch Times holds no liability for the accuracy or timeliness of the information provided.
