Fundamental Analysis

7 Reasons Stocks May Be Drastically Overvalued

Although U.S. stocks have fallen sharply from their record highs, Goldman Sachs warns that "S&P 500 valuation is stretched relative to history." That may be an understatement. Goldman looked at nine valuation metrics for the S&P 500 Index (SPX) and found that the current values for seven of them are significantly above historic averages for the period since 1976, as detailed in the table below. The data is based on Goldman's report, which is appropriately named "Where to Invest. 2019 US Equity Outlook: The Return of Risk."

7 Value Warning Signs
Metric Current Value Percentile vs. History
U.S. Market Cap / GDP 188% 98%
Enterprise Value (EV) / Sales 2.2x 91%
Cyclically Adjusted P/E (CAPE)  26.1x 81%
Price/Book (P/B) Ratio 3.2x 84%
Cash Flow Yield 7.6% 81%
Enterprise Value (EV) / EBITDA 10.9x 81%
Forward P/E Ratio 15.6x 75%
Source: Goldman Sachs

Significance For Investors

Despite a 1.5% drop in the value of the S&P 500 year-to-date through Dec. 7, seven of the nine metrics that Goldman studied are now registering higher equity valuations than 75% to 98% of the observations made since 1976. In the case of one metric — cash flow yield, which is the ratio of cash flow to stock price — the lower the figure, the higher the implied valuation. Thus, cash flow yield had been greater than it is now 81% of the time since 1976.

The current bull market has nearly quadrupled U.S. stock prices, as measured by the S&P 500, since it got underway nearly 10 years ago, in March 2009. As investor optimism about future corporate earnings growth has expanded during that time period, so have stock valuations.

The CAPE ratio has attracted particular attention from bearish observers in 2018, some of whom have cited it as signaling an impending market meltdown. It began the year at its second-highest reading ever for the S&P 500, above where it was before the Great Crash of 1929, and only exceeded by its value preceding the dotcom crash of 2000-02, as Investopedia discussed in detail earlier this year. The CAPE analysis uses inflation-adjusted average earnings per share (EPS) from the prior 10 years to derive equity valuations.

The developer of the CAPE ratio, Nobel Laureate in economics Robert Shiller of Yale University, has been warning that current market valuations are unsustainable for the long run, as discussed in another Investopedia report. He is particularly concerned about "the public's lack of healthy skepticism about corporate earnings, together with an absence of popular narratives that tie the increase in earnings to transient factors," as he has written in an essay republished by MarketWatch.

One of the biggest causes for worry may be the ratio of total U.S. stock market capitalization to GDP, a metric favored by master investor Warren Buffett. While he apparently has not made recent public comments on the matter, this indicator has been flashing warning signs to other investors and market watchers, per an earlier Investopedia article. Meanwhile, Goldman's report presents three big risks for U.S. stocks in 2019 that make high-valuation stocks more vulnerable.

3 Big Risks Ahead
Risk 1: Tariffs 2019 S&P 500 EPS may be 7% lower
Risk 2: Wage Inflation Labor costs equal to 13% of sales for typical S&P 500 firm
Risk 3: Rising Bond Yields Rapid rises in bond yields tend to depress stocks
Source: Goldman Sachs

Goldman finds that a monthly change of 20 basis points (bps) or more (either up or down) in the yield on the 10-Year U.S. Treasury Note has occurred in 44% of the months since 1962. When the yield rises by less than 20 bps in a given month, the S&P 500 can "digest" it, as Goldman writes. On the other hand, the index typically falls when the T-Note yield jumps by more than 20 bps.

Looking Ahead

In his essay, Shiller writes that "the U.S. stock market [is] the most expensive in the world," based on his CAPE ratio analysis. Given several other valuation metrics that also are well above the norms of recent history, and coupled with key risks such as those presented by Goldman, investors would do well to prepare for the possibility of yet more downdrafts in stock prices. If what Shiller calls "healthy skepticism about corporate earnings" starts to dominate investor psychology, the declines may be dramatic.

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