Almost all valuation indicators with decent track records suggest that the stock market is not just overvalued — it’s extremely overvalued.
That doesn’t necessarily mean the stock market will immediately decline significantly — though anything is possible. Valuation indicators are more helpful for long-term forecasting than short-term market timing.
It’s nevertheless worth focusing on these indicators because they provide context for Wall Street’s current focus on the burgeoning federal debt, an intractable war in the Middle East and a possible AI bubble — to name just a few of the worries du jour. It would be one thing if these worries came when the market were undervalued, and quite another, like today, when valuations are so stretched that it may not take much more straw to break the camel’s back.
The accompanying chart paints the picture. It shows the implicit return projections for nine valuation indicators, each chosen because of its statistically significant track record in forecasting the S&P 500’s subsequent 10-year real total return. Notice that seven of the nine are projecting that the S&P 500 will significantly lag inflation over the next decade, while an eighth is projecting a flat real return. Only one of the nine projects a decent return above inflation, though still well below historical norms.
The average projected return of all nine indicators is a total real return of negative 3.2% annualized over the next decade.
Bar chart showing a bearish consensus on S&P 500's projected 10-year real total return based on various financial indicators.
I am focusing on these nine indicators in tandem because, when focusing on this or that indicator in isolation, the bulls often can point to possible theoretical objections to its message. That becomes more difficult when focusing on nine different indicators with distinct ways of measuring overvaluation.
Of the nine indicators plotted in the above chart, the one with the best statistical track record is the average U.S. household’s equity allocation. The indicator’s theoretical rationale is that households are late to jump on the market’s bandwagon, and are therefore most bullish at or near tops and most bearish at or near bottoms. As you can see from the chart below, the indicator is very close to an all-time high. (This indicator was discovered many years ago by the anonymous author of the Philosophical Economics blog, who dubbed it the “single greatest predictor of future stock-market returns.”)
Chart showing average household equity allocation (inverse) and S&P 500's real total return from 1951 to 2021.
Crucially, this indicator’s theoretical rationale is distinct from each of the other eight. It has nothing to do with the ratios of price to corporate earnings, sales, book value, dividends, GDP, and so forth. And yet its message is profoundly similar to almost all of those of these other indicators.
I need to acknowledge that this indicator has been in overvalued territory for several years now, and yet the stock market on balance has continued to go up. But, contrary to what many bulls conclude, this doesn’t necessarily mean the market will continue rising. If the historical indicators have stopped working — which is the implicit argument the bulls are making — then it means we are in uncharted territory, with no clue which way the market is headed from here.
That in turn would suggest that our odds of success in the stock market are no better than those of a coin flip. Is that investing or gambling?
