The S&P 500 is having its best year since 2003, the Russell 2000 is doing even better and the Dow, up over 20%, has closed at over 16,000 and set multiple records along the way. Given these events, it should come as no shock that, according to Google Trends, the term "stock bubble," has been searched at levels not seen since October 2008. There's no doubt the market has been rallying hard, but is it at the point where it can be appropriately labeled as a bubble yet? The bubble that's in most peoples' minds and memories is the dot-com bubble of the 2000's, which gives a nice benchmark to compare the current rally with.
One way to measure whether or not stocks are overly expensive is to use the Shiller P/E ratio. This ratio uses inflation-adjusted earnings of the S&P 500 from the past ten years to avoid some of the distortions of the P/E ratio in singular years. The higher the number, the more expensive stocks are. Currently, the Shiller P/E ratio sits at 25.46. Though this number is high compared to its mean of 16.50, it pales in comparison to the high of 44.20 seen in December 1999 during the dot-com bubble.
Though the Shiller P/E is just one metric, it does provide worthy evidence that present stock prices are still much more grounded than they were during the dot-com days. It's important to note that the Shiller P/E does not predict bubbles; instead, it predicts future returns. The higher the number, the lower the returns you can expect from the S&P 500 in the years to come. The chart below shows the average 3-year real returns of the S&P given different levels of the Shiller P/E:
Just because the P/E is lower than levels seen during the early 2000's does not mean the increase in stock prices is sustainable; just that any correction at this point is likely to be far less dramatic than the one seen from the dot-com bubble.
Looking at the standard P/E ratio, we again see that stocks are not as overvalued as some believe:
The current ratio of 19.88, when compared with the historic mean of 15.50, is slightly high, but again does not point to the need for people to start worrying about a bubble.
Market Cap vs. GDP:
Another popular method (favored by Warren Buffett) of estimating whether or not stocks are overvalued compares the total market capitalization to a country's GDP. The chart below shows the past levels of United States GDP compared to market capitalization:
Using historical ratios from the past four decades, the market's valuation can be estimated with the ratio as follows:
Ratio (Total Market Cap/GDP):
Ratio < 50%
50% < Ratio < 75%
75% < Ratio < 90%
90% < Ratio < 115%
Ratio > 115%
Ratio as of 12/09/13 = 113.6%
This method of valuation again concludes that, though the market is expensive, investors need not worry about a bubble or the crash that follows. However, the data does suggest a correction is looming and that growth may slow in the following years.
Analysts calling for a correction similar to that following the dot-com bubble should rethink their positions. Though my analysis does not include any data on the NASDAQ, the index has become more diversified since the early-2000's (45% vs. 66% tech.), making its total collapse less likely. Let's also not forget that it reached 3,000 for the first time in November of 1999 and hit 4,000 just a month later before topping out at over 5,000 in March of the following year. All of a sudden, this year's gains of nearly 35% don't seem as irrational as before. Though Netflix (NFLX) and Tesla (TSLA) trade at high prices; many others, such as Google (GOOG) and Intel (INTC) are not demanding astronomical premiums.
Is the market overvalued right now? Yes. Are we in a bubble? No. The market is due for a bit of a correction, which will most likely happen when Janet Yellen finally decides it's time to start tapering. Though deals in this market are hard to come by, they're still out there. My research shows large cap stocks are a far better value than mid and small-caps. Additionally, the Shiller P/E shows the energy and utility sectors are the best values as of late.