The market is in a bubble.
By almost any measure, stocks are sharply overvalued. Warren Buffet’s favorite value metric for stocks is Total Market Cap of the market/ GDP.
Today we find this metric showing stocks as sharply overpriced. As Doug Short recently noted, only the Tech Bubble is more expensive.
This is true going back even to 1870.
Of course this doesn’t mean stocks cannot rally further. But it doesn’t bode well for long-term returns for the market in general.
This is also true from a CAPE perspective.
As I’ve noted before, the single best predictor of stock market performance is the cyclically adjusted price-to-earnings ratio or CAPE ratio.
Corporate earnings are heavily influenced by the business cycle. Typically the US experiences a boom and bust once every ten years or so. As such, companies will naturally have higher P/E’s at some points and lower P/E’s at other. This is based solely on the business cycle and nothing else.
CAPE adjusts for this by measuring the price of stocks against the average of ten years’ worth of earnings, adjusted for inflation. By doing this, it presents you with a clearer, more objective picture of a company’s ability to produce cash in any economic environment.
Based on a study completed Vanguard, CAPE was the single best metric for measuring future stock returns. Indeed, CAPE outperformed:
1. P/E ratios
2. Government Debt/ GDP
3. Dividend yield
4. The Fed Model,
…and many other metrics used by investors to predict market value.
So what is CAPE telling us today?
The CAPE is at its 3rd highest reading going back to 1890. Only the 1929 bubble and the Tech Bubble were more expensive relative to earnings.
Bear in mind… earnings are overstated. Indeed, a study performed by Duke University found that roughly 20% of publicly traded firms manipulate their earnings to make them appear better than they really are. The folks who were surveyed for this study about this practice were the actual CFOs at the firms themselves.
These practices have only worsened since the “crisis ended.” Corporations have been reducing loan loss reserves, buyback shares via debt, and axing jobs en masse in efforts to juice earnings as high as possible.
Put another way, even with RECORD HIGH profit margins, the market is overvalued on a scale rarely seen in the last 140 years. One can only imagine what the REAL CAPE would be if we removed all the accounting gimmicks from earnings.
Stocks are in a bubble. And it is one of the largest bubbles in the last century, larger even than the 2007 bubble, which preceded the 2008 Crash.
Another Crisis is coming. And based on the size of the bubble today, it will be worse than the 2008 one.
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