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3 Signs That the Stock Market May Be Too Expensive

By Diane Mtetwa – Aug 26, 2020 at 6:42AM

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These tools can help you better understand why experts are predicting a pullback.

For the last five months, the predictions that an overvalued stock market would soon correct itself have had investors on the edge of their seats. When the stock market is overvalued or "too expensive," stocks cost more than they're worth, which could lead investors like you to overpay for them. But the following three market indicators can help you better understand how to value the stock market and make sure you're buying stocks at the right price.

Confused looking man with question marks surrounding his head.

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Shiller Price-to-Earnings ratio

Developed by economist Robert Shiller, the Shiller Price-to-Earnings ratio takes the annual prices of S&P 500 companies over the last 10 years, divides them by the earnings of those companies, and adjusts for inflation. Lower numbers indicate that the stock market is undervalued, while higher numbers suggest that it's overvalued.

Over this indicator's last 20 years, its lowest point of 13.3 came on March 1, 2009, which coincides with the financial crisis recovery, and its highest point of 41.9 arrived on Sept. 1, 2000, around the time that the dot-com bubble burst. Since 2000, this ratio has averaged around 25.7, and it's currently trading just above 31 -- higher than average, but not quite dot-com territory.

S&P Dividend Yield

This metric divides the average 12-month dividend per share of the S&P 500 by the index's average stock price. Assuming that dividends are constant, the dividend yield fluctuates with share prices -- a lower dividend yield means higher and potentially overpriced stocks.

The S&P 500 dividend yield has historically averaged around 4.3%. The highest it's ever traded was 13.84% in 1932, a few years after the Great Depression, and the lowest was 1.11%, just before the dotcom crash. Currently, the dividend yield for the S & P 500 is 1.74%, which isn't much higher than the historical low.

Market Capitalization-to-GDP

This market indicator is nicknamed "the Buffett indicator" because it is a favorite of guru investor, Warren Buffett. The Buffett indicator looks at the total market capitalization of the stock market relative to GDP. When it trades over 100%, its adherents believe that stocks are overvalued; under 100%, fairly valued; and under 50%, undervalued .

This indicator traded over 100% preceding both the dot-com crash in 2000 and the global financial crisis in 2008. It is currently trading at an all-time high of 178%, sounding warning bells for a potential bear market. 

Finding value in your personal investing 

Each of these indicators has had years where they've accurately predicted market pullbacks -- but they've all had misses as well. For example, they've all suggested for the past few years that stocks are overvalued, even as the S&P 500 has almost doubled in value over the last five years.  If you'd moved all of your money to cash or reduced your stock exposure solely based on these indicators, you would've missed out on significant gains. 

Timing the markets is a fool's game, and aside from blind luck, you probably won't be able to successfully do so. Instead of using these indicators to determine when a crash is going to happen, you can use them to look for individual opportunities. Just because the market, in general, is overvalued doesn't mean that all stocks are. There are always hidden gems -- underrated stocks or industries that fall under the radar in favor of the current hot picks. 

If you're buying individual stocks, you can search for those trading below their fair value by using the same methods you've just learned. A stock market index with a high dividend yield or low P/E ratio is considered inexpensive, and so are individual stocks. You'll just want to make sure that you're comparing these stocks to relevant benchmarks, like other companies in the same industry or the stock's own historical pricing.   If you prefer diversified investments, you can buy ETFs of industries like energy and financials that have been hit hardest because of uncontrollable circumstances like COVID-19, and priced lower than usual as a result.

All of these valuation methods suggest that the markets are trading at high prices; it's simply not clear whether these high prices signal that a crash is coming soon. Whether or not the sky is falling, buying high-quality stocks or ETFs at great prices is always a sound investment move.

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