What does overvalued even mean?
Getting a good deal
In the previous posts for stocks-to-US-GDP and stocks-to-world-GDP, I mentioned that those metrics were helpful for assessing valuation. If the indicator went up (down), it could imply stocks were overvalued (undervalued).
Overvaluation implies that stocks are expensive compared to their intrinsic value, which is basically their “true” price. But, unfortunately, we can’t see a stock’s intrinsic value - all we see is the market price.
The search for a stock’s true price is why lots of people spend time doing research - to try to get a good deal on stocks by finding a stock with a market price that is less than its intrinsic value. The idea being, eventually the market price will move towards its true price and it will be a profitable purchase. That strategy is an essential part of value investing.
But maybe you don’t care about all that. You could just be one of those super strange people that buys stocks to make money. If you don’t care about all this philosophical finance discussion then let’s cut to the chase and try to figure out if “overvalued” is going to mean making less money:
In this chart, the dark line is the “S&P 500 / US GDP” ratio I mentioned earlier. The lighter line is the annualized three-year forward change in the S&P 500. Very simply, it’s how much the index rose on average over the next three years if you had invested in a given year (e.g. if you put money in 2010, what’s the return from 2011-2013?). Even more simply, it’s how much money you are making. Up is good. Down is bad.
I used annualized data in this chart for both metrics to smooth out as much noise as possible. It’s actually kind of crazy to me that even with the stock market crashing during the financial crisis, the S&P 500 three year average annualized returns never dropped below zero. That just shows how powerful of a money-making machine a diversified index of stocks can be.
I will admit though, the results aren’t as clear cut as I had hoped. Obviously, the stock market can’t be forecasted but I was hoping that this valuation metric would look a little bit stronger.
There is a clear negative correlation though. Very generally, you could say that when this valuation metric is high you can expect lower returns over the next three years than you would otherwise. And, not to get into details of some regression analysis, but the inverse relationship is also statistically significant, further supporting the valuation metric works as would be expected.
Ultimately, one metric isn’t going to predict the stock market for us. However, there is still a lot of value in having an independent benchmark to cross-check one’s thoughts on the market. A lot of people feel the market is overvalued right now and this indicator supports that. But would overvaluation really mean not investing?
Investing doesn’t have to be all or nothing. Really, the analysis ends up being what someone would expect from a valuation indicator - when the indicator implies overvaluation, you aren’t getting as good of a deal. Doesn’t mean it’s a bad deal though! There can still be lots and lots of money to be made even when things aren’t at bargain prices.
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Gross Domestic Product for the World
S&P 500 / Gross Domestic Product