Is the Market Overvalued or Undervalued?
If you follow the financial news of your country on a daily basis, there is always a market prediction associated with it. Either a bull rally is expected or a bear, but each of these are simply predictions and only lead to further uncertainty for an investor. Taking that first step towards investing can be daunting when you are bombarded with market valuations and predictions, only to realize everybody is simply throwing out their best guess at you. How do you determine that auspicious moment to enter the market when all odds are in your favor? The answer to this is NOW!
The whole idea behind value investing is to enter the market with a thorough understanding of fundamentals and WAIT. Yes, wait! Patience is what prevents an investor from making irrational and hasty decisions and exit the market when everyone shouts “SELL” or enter the market on hearing “BUY”. Only dead fish go with the flow, and our goal here is to be Alive and Minting! A famous quote by Warren Buffett sums it up clearly “Be fearful when others are greedy and greedy when others are fearful”
Now that I have you motivated and alive, let’s understand how we can use some key indicators to assess a current market valuation. The first one is analyzing the historical P/E ratio of the Index in question. If you are not familiar with market ratios and indexes you can read it here. While this type of analysis can be used for any index across the globe, I have used the S&P 500 as an example here. If you wish to download the historical data, you can find it here.
PE Ratio of S&P 500
I have plotted the index PE ratio between 1991 until 2018. During this time period, the market has seen two major recessions during 2000-2001 and the 2008 financial crisis. Note how the PE ratio during both these phases has significantly increased, reaching to a level 46 in November, 2001 and a level 123 in the year 2009. By 2009 the S&P had declined by more than 50% since 2007, because a recession forces earnings to decline. As a rule of thumb, high PE ratios indicate an overvalued market whereas low PE point to an undervalued market.
While this approach provides a useful insight into the market, it has its limitations. This method does not account for CPI to adjust past earnings to inflation. This type of P/E is termed as Schiller P/E invented by Prof. Robert Schiller of Yale university.
Another popular approach to determine market valuation is the MCAP-to-GDP Ratio, also known as The Warren Buffett Indicator.
Gross Domestic Product(GDP) is the monetary value of all finished goods and services produced within a country’s borders during a specific time period. The Buffett indicator tries to estimate market valuation by dividing the total MCAP to the current GDP of the country.
The chart above shows the historical data for this ratio, currently estimating the total MCAP for S&P as 147% times the GDP of America, showing significant overvaluation.
While this information helps us understand the current market status, various economies around the globe work in different fashions. For example, an emerging economy such as India, there are thousands of small and big enterprises that contribute towards the GDP of the country, but are not listed on the stock exchange. Therefore, the market capitalization does not account for the contributions of such companies and using this ratio alone cannot do justice to a market valuation for India. Similarly, China relies heavily on capital investments which may not offer high returns on equity. Using this indicator, the current mcap-to-gdp ratio for India stands at 69%, showing an undervalued market, however its current PE ratio is a high 32.65 showing overvaluation.
In conclusion, it is great to be knowledgeable and understand these indicators, but as stated before, any statistical analysis will be prone to errors. Investors should not stick to singular methods of analysis but look at the big picture before investing. Current markets show weak signals for a rally with looming trade wars, but for value investors, who rely on company fundamentals and the ability to wait, this is no reason to be fearful.
My goal has always been to educate and prosper from it, and I do not claim the ability to predict a market or bet on it. In such times of uncertainty, let us pledge to be informed, be patient and embrace the idea of value investing!
Be Frugal, Be Smart, Be Rich!
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