Extremely Expensive Valuations Could Lead to Stock Market Crash
In 2020, if you are bullish on the stock market, be very careful. There could be an outright stock market crash this year.
Why have such a bearish take on the stock market? Stock valuations are extremely expensive.
You see, in the short term, the stock market moves on noise and emotions. But in the long term, valuations really matter. The higher the valuations, the bigger the sell-off.
Look at previous stock market crashes. Whenever stock valuations soared significantly, eventually a rigorous sell-off followed.
Investors Paying Top Dollars for Future Earnings
Now for some perspective.
One way to look at stock valuations is to see how much investors are willing to pay for future earnings—the forward 12-month price-to-earnings (P/E) ratio.
Currently, the P/E ratio for S&P 500 companies stands at 18.6. (Source: “Earnings Insights,” Factset Research Systems Inc, January 24, 2020.)
Putting it in simple words, for every dollar of future earnings, investors are willing to pay $18.60.
Here’s the thing: this ratio stands above its five-year average (16.7) and its 10-year average (14.9).
Scary.
Looking at This Ratio, Even Warren Buffett Wouldn’t Buy
The P/E ratio isn’t the only valuation measure saying stocks are expensive and the odds of a stock market crash are stacking higher.
Look at the total market capitalization to gross domestic product (GDP) ratio. This ratio essentially looks at the size of the stock market relative to the size of the economy. Mind you, this indicator is closely followed by Warren Buffett.
How to read this ratio? If it’s over 115%, it means the stock market is extremely overvalued.
At the time of this writing, the total market capitalization to GDP ratio stands at 153%. (Source: “Buffett Indicator: Where Are We with Market Valuations?” GuruFocus, last accessed January 29, 2020.)
This Ratio Says Stock Market Is Overvalued By 80%
Another valuation indicator is the cyclically adjusted P/E (CAPE) ratio. This is the P/E ratio adjusted for inflation and business cycles. It’s a better measure of stock market valuation than the simple P/E ratio.
Currently, the CAPE ratio stands above 30. This is about 80% above its historical average, and it has been persistently around this level for a while. The last time the CAPE ratio was much higher than this was during the tech bubble.
Here’s What Investors Could Do
Dear reader, the three valuation measures pointed out here are really painting a dire outlook for the stock market. They are pretty loud and clear about it.
We have had a solid run to the upside over the past 10 years or so. But you really have to wonder how long this bull market can continue.
2020 could turn out to be a tough year for the stock market. It wouldn’t be shocking to see a stock market crash. The next few years may not be as great as 2019 was. If you risk your capital on the stock market, be very selective and pick individual stocks instead of an index fund.