If you are a trader, you don’t care how the market stacks up to past fundamentals.
But, if you are a long-term investor, knowing how the market appears today from a fundamental standpoint, compared to other times, is something you want to keep an eye on.
Knowing when the market is becoming expensive or even overpriced is essential because that tells you it may be time to start taking your foot off the gas. Or the other side of that coin is that the market appears cheap or underpriced.
These times are when the words of Warren Buffett, “Be greedy when others are fearful and fearful when others are greedy,” stand out the most to me.
Buffett is trying to tell investors that when others are buying, despite stocks and the market as a whole being very expensive, you should be concerned. He also says that you should be greedy when others are afraid, likely because of market turmoil and stocks are selling off. Buffett gives you a straightforward, back-of-the-napkin blueprint of when to sell and buy.
With that all said, I don’t believe there are hard-pressed rules on this is when to sell, or this is when to buy.
However, I think now is a time that you should start considering when you will sell or, at the very least, start planning your next moves based on how the market reacts to the coming weeks or months.
One reason I believe we may be hitting a peak is because of general market sentiment. Towards the end of the summer, most market participants, the talking heads on news outlets, and even Wall Street (i.e., the big banks) were saying a recession was very likely in 2023.
However, the market was rallying during that time, then we peaked in August and finally sold off in September. During the fall, the markets were mostly flat, and then things spiked in January. Now the thinking is we may not hit a recession, and inflation may be behind us. Is the market feeling like it could be getting greedy?
But what about the complex data showing us the markets may be overvalued right now?
The S&P 500 currently trades at a Price-to-Earnings ratio, or PE ratio, of 21.33. Looking back to the 1870s, the mean PE ratio is 15.99, and the median is 14.91. So, we are on the higher end of the average.
The S&P 500 is also trading at a 4.01 Price-to-Book ratio. Looking back to 2000, the mean is 2.96, and the median is 2.81. Again, we are on the higher end.
When we look at the S&P 500 Price-to-Sales ratio, we are currently at 2.33. The mean going back to 2000 is 1.68, while the median is 1.54. Once again, we are sitting on the higher end.
Finally, the famous Shiller PE ratio, based on the average inflation-adjusted earnings from the previous ten years and developed by Robert Shiller, is currently at 28.99. Looking back to the 1870s, the mean is 17, while the median is 15.91. The high for the Shiller PE was in 1999 at 44.19. However, we are currently above where the Shiller PE was before the financial crisis in 2007-2008 and just a point below where the market sat prior to Black Tuesday in 1929.
All the figures above are single points in time and not crystal balls telling us that the market is about to crash.
For all we know, the market could go higher for another month, year, or ten years. Valuations could continue to get further and further stretched. But, based on historical data, we are entering valuation levels where we typically see pullbacks in the market.
And on top of the fundamentals telling us we are getting overpriced, we still have high inflation, a Federal Reserve that is continuing to increase interest rates, companies announcing layoffs, and a possible recession soon.
I don’t believe the market will start a massive, smooth decline tomorrow, this week, or even next month.
But, I am trying to stress that we need to start planning about what we will do when it becomes clear that we are heading lower.
My advice is to start looking at ways to hedge your portfolio against a significant downturn. This means you buy an exchange-traded fund that will increase in value if the market turns negative. Two good options to consider are something like Direxion Daily S&P 500 Bear 1X Shares ETN (SPDN) or the Proshares Short QQQ (PSQ).
For more ideas, check out this article I wrote in the summer.
Final thought; this is not a doom-and-gloom article trying to scare anyone.
This is simply a reminder that sometimes the market does turn negative and that we don’t want to be blind to the idea that, at times, stocks are overpriced. Now they can remain overpriced for an extended period. But, eventually, the pendulum will swing in the other direction, so be prepared when that occurs.
Follow me on Twitter @mthalman5513
Disclosure: This contributor did not hold a position in any investment mentioned above at the time this blog post was published. This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.
2 thoughts on “The Market Is Looking Expensive”
Hey Matt. I agree with most of what you say here. Although certain spots of the market have gotten much cheaper, on average it's still relatively expensive out there. The current 2-month rally hasn't helped things that much from a valuation standpoint, although I believe a lot of that is re-positioning after one of the greatest tax-loss-harvesting quarters in history.
That rally has brought many of the high % index components back in staggering recovery, with names like META, NVDA, TSLA, etc. gaining 30-80% in these first two months of the year. So we see a further concentration of capital that also skews the picture.
If we see earnings expectations adjusted down again, which could happen given the fed stance, the current pricing may look outrageously expensive. Only time will tell.
I tend to prefer watching P/S ratio also, rather than P/E. PE is the more popular metric of course, but there are so many more variables that can manipulate a company's P/E ratio, whether intentional or not. And P/S ratios are still high as well. We shall see.
One note to add, as a trader who has also spent many years managing for the long-term, I do think traders should pay attention to valuation and macro trends. Of course, not the same way an investor would. But, for a simple recent example... If one of your strategies was buying outsized gaps down, you wouldn't want to do that in a time of macro contraction, and you wouldn't want to do it in overvalued names. Both of those things greatly diminish your odds. "Catching knives" can work quite well when everything is in an upcycle. Not so much when cycles shift and valuations readjust.
I'm new to INO and was pleasantly surprised with your post and the analysis of our current market.
I just started my 4th year trading and am becoming VERY MINDFUL about our global macro view versus prices of stocks and strike prices for options.
Keeping this short -- I'll check your posts elsewhere and thanks!