Is the Stock Market Overvalued? The Finale.

November 17th, 2013 by 

This is the end... my only friend.  The end.

We've taken you on a journey in the last 4 pieces - everywhere to academia to Omaha to main street - just to bring you back here with that same question burning in your brain.

"Well, is the market overvalued?" you may still be asking, or "what does all of this mean?".

I'm not cruel enough to introduce more indicators to muddy the waters, but let's discuss what these valuation methods mean.

(Oh, and for your perusal, here is the rest of the series)

See Part I – Robert Shiller

See Part II – Warren Buffett

See Part III – James Tobin

See Part IV - Main Street

See The Finale - What Does it Mean?

Slight Overvaluation?

Let's rundown the three academic valuation methods:

  • Shiller CAPE - 24.42 versus a 16.36 average valuation = 49.27% overvalued
  • Buffett Market/GNP - 1.0 versus fair value of .80  = 25% overvalued
  • Tobin Q - .92 versus a .69 average valuation = 33.3% overvalued

Okay, sure, they're all flashing red or at least orange... but so far all we've got are numbers in a vacuum.  Now, I could plot various values with various yearly returns and toss you an R^2 and call it a day.  I won't do that to you - but let's talk about what, exactly, an investment is worth, especially when applied to the stock market.

What Gives A Stock Value?

(Don't care?  Skip to the next section... expected returns!)

You've probably heard it before - a stock's true value to an individual investor is its claim on future earnings.  Seriously - that's it.  To a trader, a stock might have value because of volatility or some other meta-indicator, but for all of the retail investors, hedge funds, pension funds, endowment funds, mutual funds and others in the long market, it's all about the earnings ("Show me the money!").  So, what 'makes up' the valuation?

Well, first, there are two easy aspects: earnings themselves, and the oft-forgotten dividends.  (So oft-forgotten that we have two calculators dedicated to dividend reinvestment on the S&P 500).

The third one is the weird one, mostly because it involves all of the wonky stuff that we have to toss into a basket - perceptions of risk and all that.  Yes, the third factor is 'valuation'... as in 'what is the future of this company worth?' or 'what is the future of this market worth?' for the purposes of this article:

Stock Price =

Earnings + Dividends + 'Valuation', which boils down to:

Earnings Growth + Dividend Yield + Change in Valuation Based on Our Fair Value Estimates

Okay, maybe we're just "dividing quantities by other quantities purely for the fun of it."  (or, if you prefer... the adult language formulation).  Still, let's holistically look at our 3 first indicators through the lens of the next ten years - since that usually covers one whole market cycle.

(Follow along with the dividends on the ETF 'SPY', retrieved 11/13 Morning, the compounded GNP growth over the last 10 years and the change in the first three valuations)

1.93% + 3.99% + X = 5.92% + X%

As for X?  We have to adjust our three (formulaic) valuations to fill in for X.  Scaling it is easy: ("Expected Valuation"/"Current Valuation")^(1/Number of Years) - 1.  1 is a standin for 100% since we're calculating change.

  • Shiller: (16.36/24.42)^(1/10)-1 = -3.926%
  • Buffett: (.80/1.0)^(1/10)-1 = -2.207%
  • Tobin: (.69/.92)^(1/10)-1 = -2.836%

Expected Returns

Whew, got all that?  Here's what that pencils out to:

  • Shiller: 1.994% annual returns over the next 10 years
  • Buffett: 3.713% annual returns over the next 10 years
  • Tobin: 3.084% annual returns over the next 10 years

As of 11/12, the 10 year Treasury was yielding 2.80%.

I'm just saying - at some point risk outweighs reward... but that's up to you.

A Discussion of Caveats

I recognize some of you will take exception to the 'dividend' section... "Well, PK, that ratio will raise or decrease with the market price!".

Yes, but remember - this is for a purchase today, and future dividend growth relies on earnings growth.  If you want to haggle on estimates, I would prefer we discussed the business growth rate.  For the purposes of our calculation, I used the growth in GNP over the last 10 years, annualized.  If you think that is too high or too low... that's where the issues with these calculations stand.

Beware of false precision, too.  Just because I have a number of significant digits doesn't mean my estimates are perfect.  Consider them, if I'm lucky, a ballpark figure.  And here's the other point.... if GNP estimates earnings trends at all, it's possible for even an overvalued market to give you a positive return.

And isn't that a nice idea?  Four articles in and here I am to tell you - it could be worse, and even if you buy the top you might come out on top in a decade or so.

Does that help you sleep at night?




PK started DQYDJ in 2009 to research and discuss finance and investing and help answer financial questions. He's expanded DQYDJ to build visualizations, calculators, and interactive tools.

PK lives in New Hampshire with his wife, kids, and dog.

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