Stocks Overvalued, Bear Market Coming
The bull market celebrated its eighth anniversary on March 9, 2017, and equities are at record levels. But investors should be prepared for the bull market to end and the bear market to begin in 2017. That’s because the current bull market has been fuelled by years and years of artificially low interest rates and, most recently, optimism around Donald Trump’s pro-growth policies—not strong earnings and revenue growth.
While we are currently in the second-longest bull market in history, the cheering has been a little muted. After all, the stock market is only as strong as the underlying stocks that make it up. By all accounts, the U.S. economy is not doing well, and elevated stock levels cannot be sustained.
Despite the longevity of the bull market, the U.S. is in the midst of the slowest economic recovery since WWII. For starters, President Obama is also the only U.S. president to have never logged one year of three percent gross domestic product (GDP) growth. During Obama’s presidency, the U.S. economy grew, on average, just two percent. In the 10 previous expansions, real GDP grew an average 4.3%.
In 2016, the last year of Obama’s presidency, GDP was 1.6%—the worst since 2011 and the fourth worst in 25 years. Meanwhile, President Trump pledged on the campaign trail to get U.S. GDP to four percent. Despite Trump’s proposed tax cuts and increased spending, that’s going to be tough to do.1
Meanwhile, on Wall Street, the S&P 500 only recently emerged from the longest earnings recession on record. Despite the slow economic growth and two years of poor earnings, the S&P 500 and Dow Jones Industrial Average climbed to record levels.
Income-starved investors have turned their back on fundamentals and are instead trading based solely on technicals and momentum. This has sent stocks to unsustainable levels, levels not seen since 1929 (Black Tuesday) and, most recently, 2000 (dotcom crash).
Wall Street may be optimistic about Donald Trump, but the fact remains that there is nothing to support the eight-year-old bull market. As a result, 2017 could very well be the year the overvalued stock market experiences a major correction and stocks enter a bear market.
For the record, since WWII, the S&P 500 has experienced 15 bear markets. On average, the bear markets lasted around one year and stocks fell approximately 30%. It takes a long time for stocks to reach their pre-bear market levels too. The longest period was after the 2000-2002 bear market; it took 68 months for the S&P 500 to recover from the bear market. After the financial crisis and recession in 2007, it took the S&P 500 53 months to recover.
3 Key Indicators Show Stock Market Significantly Overvalued
How do we know stocks are overvalued? Three of the most important indicators suggest the S&P 500 and broader markets are significantly overvalued and ripe for a correction.
The cyclically adjusted price-earnings (CAPE) ratio, which helped Yale economist Robert Shiller earn the Nobel Prize in Economics in 2013, compares current prices to average earnings over the last 10 years. The CAPE ratio is currently at 28.95; the long-term average is 16. This suggest the S&P 500 is overvalued by 81%. The CAPE ratio has only been higher twice: in 1929 it was at 30 and in 1999 it was at 45.
The Market Cap to GDP ratio, which is also known as the Warren Buffett Indicator, also shows the stock market to be seriously overvalued. The ratio is at 130.5%. A reading of 100% shows stocks are fairly valued. The ratio has only been higher once since 1950. During the dotcom bubble in 1999, it was at 153.6%.
Lastly, the Wilshire 5000 to GDP ratio weighs all actively traded, U.S.-headquartered stocks on the major exchanges. It is the largest index in the world based by market value. It is at an all-time high of approximately 140.5.
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- “Gross Domestic Product: Fourth Quarter and Annual 2016 (Third Estimate),” Bureau of Economic Analysis, March 30, 2017; https://www.bea.gov/newsreleases/national/gdp/2017/gdp4q16_3rd.htm
- “Case Shiller P/E Ratio,” Yale University, last accessed April 10, 2017; http://www.econ.yale.edu/~shiller/data.htm.
- “Wilshire 5000 Total Market Full Cap Index©/Gross Domestic Product,” Federal Reserve Bank of St, Louis, last accessed April 10, 2017; https://fred.stlouisfed.org/graph/?g=qLC.
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