It’s no secret that the S&P 500 has been on a tear since January 2009. The S&P 500 consists of the 500 largest companies on the NYSE and NASDAQ (the two biggest stock exchanges in the US). With dividends reinvested, the total return of the S&P 500 from January 2009 to January 2017 has been 208% or 15% annualized.
But what should be expected from the S&P 500 and overall US stock market going forward?
Just because the S&P 500 has advanced over 200% during this period doesn’t necessarily mean it’s overvalued. You have to look at its valuation. For example, one valuation metric is to compare the price of the S&P 500 to the earnings of all of the 500 companies.
I like to look at three metrics when determining whether the S&P 500 and the overall US stock market is undervalued, fairly valued, or overvalued. I think this is a particularly important exercise if I’m buying ETFs that follow the market. I also find it important when determining how much cash to hold in my investment accounts.
- The Shiller P/E ratio
- This ratio is calculated by dividing the current price of the S&P 500 by the average inflation adjusted earnings of the S&P 500 for the past 10 years. Taking 10 years of earnings accounts for fluctuations in the earnings of companies (such as recessions and boom times). This levels out the earnings. The ratio is currently 28.16. The only time the ratio has been this high is before the crash of 1929 which led to the Great Depression and when the Dot-Com bubble burst in 2001. Sure interest rates are low right now which has inflated the value of stocks but the Fed has indicated that they will raise rates three times in 2017. This could lower future stock returns as companies may be paying more in interest payments on debt and consumers may be doing the same and spending less.
- Total Stock Market/GDP
- The total stock market/GDP ratio is considered by Warren Buffett as “probably the best single measure of where valuations stand at any given moment.” Currently the total stock market/GDP is 127.7% and based on the historical ratio, the US stock market is poised to return -0.5% a year from now, including dividends.
- Q Ratio
- This is calculated as the total price of the market divided by the replacement cost of all its companies. The current ratio is 47% above the mean which means the ratio is in the range of the peaks before the Dot-Com bubble, Great Recession, and Great Depression.
So what do these three ratios tell us? They indicate that the S&P 500 and US stock market as a whole is overvalued at the moment. This is based on what companies are earning and how the economy is doing. I’ve been finding individual stocks are also mostly overvalued with the exception of a few such as Nike which I’ll be writing about.
In my investment planning, I’m expecting lower returns going forward as valuations compress to more normal levels. An important concept to keep in mind is reversion to the mean where prices eventually return back toward the mean. In anticipation of this, I’m accumulating cash in my investment accounts. I’m doing this by using savings from my employment income and piling up cash from my dividends. I’m not selling my existing investments as I bought them at lower valuations and the companies continue to deliver performance.
I plan to hold cash in the range of 15% to 20% in my investment accounts in the event there is a pull back in valuations in the near future and stock prices fall. With this said, the stock market can stay irrationally overvalued for quite some time. However, patience should be rewarded as stock market valuations will eventually return to normal levels once interest levels normalize.