Setting Up for the Slaughter

Stock Market Valuations Touching Historical ExtremesInvestors poured $4.3 billion into the SPDR S&P 500 (NYSE/SPY) last week, an exchange-traded fund (ETF) that tracks the S&P 500. For the week, ETFs tracking U.S. equities witnessed the most inflows in the last four weeks. (Source: Reuters, July 17, 2014.)

And as investors continue to inject vast sums of money into the stocks, stock valuations are at historical extremes. When I want to see how expensive the stock market is getting, I look at the S&P 500 Shiller P/E multiple (the value of stocks compared to what they earn adjusted for inflation)…and it’s screaming overvalued.

In July, the S&P 500 Shiller P/E stood at 25.96. That means that for every $1.00 a company makes, investors are willing to pay $25.96. The stock market has reached this P/E valuation (25.96) only seven percent of the time since 1881.

The number suggests the stock market is overvalued by 57%, according to its historical average of 16.55. (Source: Yale University web site, last accessed July 18, 2014.) The last time the S&P 500 Shiller P/E was above the current level was in October of 2007—just before one of the worst market sell-offs in history.

But this isn’t the only indicator suggesting the stock market is overvalued.

Another indicator of stock market valuation I look at is called the market capitalization-to-GDP multiple. Very simply put, this indicator is a gauge of the value of the stock market compared to the overall economy. It has been a good predictor of where key stock indices will head.

At the end of the first quarter of this year, the Wilshire 5000 Full Cap Price Index was valued at $19.64 trillion. That means that if you add up the market values of all the companies that trade on the Wilshire 5000, they will total $19.64 trillion. U.S. gross domestic product (GDP) at the end of the first quarter was $17.01 trillion. (Source: Federal Reserve Bank of St. Louis web site, last accessed July 18, 2014.)

This put the market capitalization-to-GDP multiple at 1.15. Historically, since 1971, the average has been 0.70—the stock market has been worth seven-tenths of the economy. Today, it is worth 115% of the economy. According to this measure, the stock market is overvalued by 64.28%.

Looking at all this, I can say with certainty that the current stock market doesn’t fit the description of “buy low, sell high” anymore because it’s way overpriced.

The only question that remains is when will the market sell-off hit? Well, from my experience, when irrationality peaks, it tends to do crazy things. And it wouldn’t surprise me if investors become even more irrational and take the stock market even higher, as irrationality can often go on for a long time. (Think the U.S. housing market of 2004 to 2006.)

For my risk/reward model, in my view, the stock market is offering much more risk than reward at this point.