Proceed With Caution As Markets Reaching Tipping Point According to These Indicators

September 14, 2014 • Education

Chatter about markets being overvalued has been going around for a couple of years now with the linear rise in prices. Fundamental indicators support the overvalued thesis, yet that has not stopped the DOW (DIA) or S&P (SPY) from reaching highs.  Below, I will compare the current standing with historic figures to show why investors should proceed with caution.

Buffet Indicator: Total Market Cap/GDP

Buffett’s favorite metric compares the total price of all publicly traded companies to GDP. “Probably the best single measure of where valuations stand at any given moment” is how Warren Buffett has described this indicator.

The numerator takes the market value of equities outstanding from the Federal Reserve site. The GDP denominator includes a Q2 GDP growth estimate of 2.37% (the QoQ growth in Wilshire 5000 value). The Fed is expected to release this figure September 26th. A more detailed explanation of the Buffet Indicator can be read here. Also, an interactive version of the chart can be found on FRED graph.

buffet indicator

 

What does this mean?

Currently market cap/GDP ratio stands at 125.5% or the second highest value since the peak of tech bubble in 2000. As seen above, we have passed the 2007 housing bubble peak of 112.1%. When comparing historic values all the way back to 1950, current market valuation with respect to GDP is approaching alarming levels.

If statistical measures (the mean and standard deviation) are used to define the ranges of the indicator, the chart can be interpreted:

1950 ranges

 

Assuming that a fairly valued market is one standard deviation above the historic mean, any value greater than two standard deviations (>119%) should be considered significantly overvalued. In the last 20 years, by the measures classified above, the market has been at least “overvalued” 60% of the time. Today, we stand at 125.5%, considerably above the 119% “severely overvalued” benchmark.

Low Interest Environment Creating New Standard in Markets?

With interest rates around all time lows, equities have been the only viable option for investors. This has surely contributed to the market appreciation and market cap/GDP levels above historic norms. To see the potential effects a low interest rate environment (10yr US yield < 4%) would have on markets, the last 7 years (since late 2007) were analyzed. During this time, the market cap/GDP ratio has had a mean of 97% with a 16% standard deviation.

2007 ranges

 

According to the criteria above, our market would still have some room to run before being classified as “severely overvalued”.

The IMF projects US GDP to grow by an average of ~3% in 2015. Assuming that the market cap/GDP benchmark for a severely overvalued market is at 129%, the market presents additional upside of ~9% current levels.

However, there are flaws with the above criteria. First, the sample size (7 years) does not offer sufficient enough data to reach a decisive conclusion. Additionally, globalization has reduced the reliance of US economic activity as nearly half of earnings are coming from overseas. Therefore, using US GDP as an economic indicator paints a partial picture.

What’s Driving Corporate Profits?

Corporate profits as a percentage of GDP hit all time highs in 2013 at 9.74% (dark line below).

corporate profits gdp vs change in consumer spending yoy

 

Rising profits are a function of top line growth or expense cutting. Revenue growth is driven by consumer spending. Ideally, rising corporate profits are healthiest when consumers are spending to drive revenues, which then trickle down to the bottom line. In recent history, this was portrayed during the buildup to the 2007 housing crash (although spending was driven by debt) and after the “Great Recession”.

Since 2011 though, consumer spending has slowed while corporate profits have continued rising. Thus, rising profits are due to factors such as cost cutting and share buybacks, both possible with cheap available credit. Such a method is unsustainable, however, as interest rates will inevitably rise, buybacks will slow and further cost cutting will affect productivity. Unless we start seeing significant revenue expansion, it seems corporate profitability will not reach much higher levels. Once profits wane, so will valuations.

Conclusion

Above are two indicators that point to an overvalued market. In a historic comparison, the market value of equities is nearing levels that are abnormally high, no matter which time frame is taken into account. Corporate profits, which Wall Street holds accountable for the current market valuation, have hit an all time high on factors that are unsustainable. It is often said that bull markets don’t die of old age, but with an expected rise in interest rates in 2015, this bull market may be on its death bed.

End of Bull Market
What, if anything, do you think will put an end to this bull market?

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