As the world begins to emerge from their homes and return to the market crowd, a familiar sense of normalcy seems near. However, the rubble left by a global pandemic is not yet completely in our past. With unemployment rates still above pre-COVID levels and many small businesses continuing to struggle, it would seem reasonable to expect that the market has not yet returned to the same strength as before the pandemic. However, this is not the case; the stock market has experienced a record rally and is now reaching all-time highs. As Michael Arone, chief investment strategist at State Street Global Advisors said, “… investors continue to question why the stock market could behave so strongly when the economy, labor market and incomes face such challenges. ”
While it is possible to ignore this spread and assume that it is part of the natural ups and downs of the market, it may not take into account how historic highs have been followed so closely by historic lows. The Schiller PE Ratio, which calculates the S&P market’s price per earnings for the past 10 years, and is a relatively good indicator if the market is overvalued, currently stands at 37.8, up from a historical average of 16.5. This means that investors are prepared to pay a premium of 130% to own shares of the S&P 500.
Historically, there are only two other times that Schiller’s PE ratio has reached this level: in the months leading up to the Great Depression and just before the dot-com bubble collapsed. The Wilshire 5000 GDP ratio, which compares the total value of the US stock market to US GDP, currently stands at 1.9 compared to the historic average of 0.83. In today’s economy, this large gap between market valuation and actual gross income can be a red flag.
There are two main factors that can cause the stock market to be overvalued today. In order to combat the economic distress of recent times, the US government has kept interest rates low so Americans can borrow more money, spend it in the market, and stimulate the economy. To make money more accessible and to keep rates low, central banks printed more money. The production of money and the subsequent expenditure that occurs in the market inflates prices. With low interest rates, Americans have an incentive to move their money from their low-yielding bank accounts to more lucrative investments, such as real estate and the stock market, which has contributed to the upward trend of asset inflation.
The second contribution to the market rise is the continued influx of new investors and a frenzy of speculation. With easier access to investing in the market and the new popularity of “fad stocks”, many uneducated investors are simply jumping in the path. As Jeremy Grantham, chief investment strategist, said, “There is nothing more annoying than watching your neighbor get rich.” Both the Bitcoin craze and GameStop are prime examples of this attitude. In the age of social media, it has never been easier to see your friends earning a triple-digit percentage on a trending stock. The desire to buy, too, only contributes to the inflation of prices which are not necessarily supported by value. This cyclical nature of buying threatens the market.
Regarding times of speculation, Charlie Munger, Vice President of Berkshire Hathaway, commented: “Well, these things happen in a market economy. You get crazy booms … My policy has always been to just overcome them … [Many] buying stocks frantically because they see that they are going up, and that is a very dangerous way to invest. Whether or not a crash ensues, it’s important to keep in mind that value-based investing will always prevail in the long run, and patience is your best friend.
Photo caption: As the market source continues to thrive, many economists argue that investors are only destined to uncover a mirage.
Photo credit: Pixabay