Is A Correction On The Horizon? Look Warren Buffett's Way

| About: SPDR S&P (SPY)
This article is now exclusive for PRO subscribers.

Summary

Since Trump won the Presidential Election, stocks have been on a tear but is it possible that the markets are overheating?

To find the answer to this, I looked at three different metrics that have pretty decent records of pointing out extreme market valuations.

One of these was touted by Warren Buffett but the other two are very significant as well.

Taken together, it seems the market is very pricey and could or should correct but don't confuse this with the US economy.

How much higher can it go? This is probably a question you've asked recently if you watch the markets on a day-to-day basis. Since Donald Trump won the Presidential Election, markets have soared higher, with the S&P 500 (NYSEARCA:SPY) rising 6.2% as of the time of this writing. Meanwhile, the Dow Jones Industrial Average is up 8.6% and even the NASDAQ is up 5.2%. In what follows, I will give my thoughts on where we are from a market pricing perspective and tell you why I think we may be in the danger zone right now.

Separating health from performance

Before I begin, allow me to make a very clear distinction between my thoughts on the economy vs. my thoughts on the stock market. While the market tends to point in the same way as the economy, the two are very different and should be look at as such. Personally, I began to sense, based on the data I was seeing, that the US economy is picking up steam probably a month or so before the election (and no, I don't think any economic performance data would be different right now based on the results of the election because neither candidate can implement any policies until after they have been sworn in).

While I don't feel qualified to say much about the economies in Europe or in Japan (I don't follow those areas much), I have also been seeing some upbeat data from China, which would ultimately prove bullish for other nations down the road. I am still very concerned about China's housing bubble but performance in some areas like casinos, which I believe are a good indicator of the nation's growth, suggests that the nation may see an uptick in GDP at some point in time.

In essence, what I propose regarding my thoughts on the market are independent of my thoughts on the economy. I do believe the US is perfectly fine and is unlikely to see a recession over the next year or two (absent an external shock) and I especially don't see any major triggers like a mortgage bubble forming (though the student loan bubble is disconcerting, as is data regarding subprime cars). With this in mind, I am now going to give my thoughts on why, despite seeing an improving economy, we may be setting ourselves up for trouble from an investment perspective. In order to do this, I will look at three specific pricing indicators and will give my opinion regarding each one.

The Shiller P/E

One of the most popular metrics for looking at where the market is priced is the Shiller P/E (Price/Earnings ratio). Unlike with the regular P/E, the Shiller P/E looks at the market through the lens of the cyclically-adjusted price/earnings ratio, not just the price/earnings ratio. The difference here is that, as opposed to the S&P's earnings in any given year, the Shiller P/E's denominator is what the average of earnings have been over the past decade, all of which is adjusted for inflation. The idea here, following in the footsteps of Benjamin Graham, is to "smooth" out earnings over time.

*Taken from multpl.com

In the graph above, you can see what the Shiller P/E currently looks like. With this recent rally, the ratio has soared to 28.09 times earnings as of the time of this writing. This takes the metric above the highest point of 27.55 times in May of 2007 when the economic crisis was unfolding and is more than double the recent low of 13.32 times seen in March of 2009. Scarily enough, there are only two times in recorded history that this metric was above current levels; the Dot-Com bubble and right before The Great Depression. The last major economic downturn is a close runner up to today's price.

Now, before you go running for the hills, keep in mind that this metric is not perfect. Take, for instance, a period of time where earnings were incredibly low (less than a decade ago we were in the midst of the second-worst economic crisis of the past 100 years) and also consider what happens if, moving forward, earnings start to grow at a nice clip. This metric would still weight the earnings from the last crisis at the same rate that it would the strong earnings moving forward (and the ones moving forward are what's important) so there is some risk that wild swings in earnings will distort it and give off an inappropriate reading. With that in mind, however, we should also be cognizant of the fact that it's not that nice to be in the same company as investors who experienced the three greatest bubbles in recent decades.

Tobin's Q Ratio

The second metric I decided to look at is Tobin's Q Ratio. This is a measurement that I've followed for a few years now but have rarely come across anybody who has taken it into account. This metric is defined as the market value of publicly-traded stocks divided by the replacement cost of said firms' assets and can be seen in the image below.

*Taken from Advisor Perspectives

What you can see by looking at where we are at using Tobin's Q is that the market appears to be pretty price at the moment. Compared to a historical average ratio of 0.68, we are trading at a premium of 52.9% with a ratio of 1.04. If this were a perfect measurement of the market's value, we could expect a rather substantial decline in order to get us back to the mean of what's reasonable. Just as in the case of the Shiller P/E, Tobin's Q actually means that we are in the same range as investors who were in the market during the Dot-Com bubble and during the start of The Great Depression.

Just as was the case with the Shiller P/E, however, there are some bugs in this model. For starters, besides factoring in the uncertainty of calculating the replacement costs of the companies that make up the market, we must also consider that replacement costs, as defined as the book value of assets, can fluctuate meaningfully based on economic considerations. One such example is with oil. For energy companies that have taken a beating and written down assets, those writedowns cannot be reversed should the market continue to recover like it has, meaning that, for a while at least, book values may be understated and the ratio would be overstated as well. The other issue is that Tobin's Q is not a perfect indicator of a bubble. If you look carefully at the graph I provided, it failed to indicate the 2007/2008 financial crisis.

The "Buffett" Indicator

The last metric I decided to look at is the Market Cap / GDP Ratio (Buffett uses GNP but they are close enough that the results aren't materially different). In the past, Buffett, CEO of Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B), has invoked this metric, which is merely the market value of all publicly-traded companies divided by the size of our economy. In the graph below, you can see the current ratio.

*Taken from Guru Focus

Based on this data, the market seems to be incredibly overpriced. Right now, the ratio stands at about 127.3% and every time, dating back to at least around 1970, that this measure went above 100%, the market did, eventually, fall back below that level. This is actually my favorite ratio because it is fairly simple, even though it does not consider that the market will likely react before GDP sees a measurable impact from changes in economic conditions. This means that it is possible for the metric to get ahead of itself on both the upside and downside.

Takeaway

Right now, if you look at three very interesting methods of valuing the market, it's clear that stocks are pricey but is this kind of elevated price justifiable or are we due for another correction? Personally, I wouldn't be surprised to see a sizable downturn (10% or more) in the market at some point in time but for me to figure out when that might be is a fool's game and I'd be better off playing the lottery. Also, just because a correction is very likely at some point based on these metrics, it doesn't mean that it will happen this year or next or the one after that, and it doesn't take into consideration the possibility that this time might be different (though it never has been "different" before).

Due to these factors, I am not going to rush out and sell my shares anytime soon. I do believe the economy is improving and I have positioned my portfolio in the most optimal way I can think of to benefit from a growing economy but investors who believe, like me, that markets and the economy are two very distinct things should continue to keep a watchful eye on these metrics because if some large economic event does take place and/or if we see even a modest recession, then the ride down could be meaningful and laced with pain.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.