How to tell if the market is overvalued or undervalued

The short version

• Investors who want to know if the market is undervalued or overvalued can use a few key metrics to help gauge where the market is.
• The key metrics are the P/E, the Buffet indicator, Tobin's Q, margin debt and inverted yield curve.
• Keep in mind that each metric has its downsides, and no one indicator can predict the next stock market downturn.

Discover how a simple decision today could lead to an extra $1.3 million in retirement

Learn how you can set yourself up for a more prosperous future by exploring why so many people who work with financial advisors retire with more wealth.

Discover the full story and see how you could be on the path to an extra $1.3 million in retirement.

Read More

5 ways to tell if the stock market is undervalued or overvalued

1. P/E and Shiller P/E

The first indicator — the most often quoted metric for a company — is the P/E ratio. This is simply the ratio of stock price to company earnings. The logic is that a stock will have a premium over the net income the business generates over a 12-month period. How much of a premium is what really gauges how over- or under-valued a company is. High-growth companies generally command higher P/E ratios because investors are betting on higher future earnings and are willing to pay for them.

When it comes to using the P/E ratio as a valuation tool for the market, you need to look at the long-term average P/E. Compare this with where it stands today. Of course that long-term average includes many bear markets. So when we are in the middle of a bull market, we expect higher numbers. But if the average P/E ratio is higher than ever before, the market is more likely to be overvalued. For reference, the current S&P 500 ratio stands at 34.5. And this suggests the market is overvalued.

One argument against using this system is that earnings vary significantly over the course of a business cycle. These cycles typically last between seven and 10 years. This means comparing the current and average P/E ratios can be misleading, depending where we are in the business cycle. To smooth out this issue, award-winning economist Robert Shiller devised the cyclically adjusted P/E ratio (CAPE), or Shiller P/E ratio.

The Schiller P/E ratio smooths out the volatility by taking the average of the last 10 years of earnings and adjusts them for inflation. This lessens inflationary impacts that may distort earnings figures. The goal with this indicator is to get a more accurate number that can be compared with historical figures.

Criticisms

Keep in mind that while these are two of the most followed indicators in the markets, they have shortcomings. For example, interest rates have, on average, only gone down since the 1980s. When people can't earn money on their savings, they invest more money in stocks, which of course raises prices. And this translates to elevated P/E ratios. So, while the P/E ratio of today seems high, it must be taken within the context of lower interest rates.

More: P/E ratio primer

2. The Buffet Indicator

Another widely followed metric is the Buffett indicator, created by Warren Buffet. He recommends investors use this indicator to better gauge the general state of the market.

This indicator divides the total stock market valuation by the nation's gross domestic product (GDP). This gives us a rough estimate of the state of valuations in the market. The theory states that market valuations should track GDP. Think of it as the stock market following the real economy.

Of course, as markets are forward looking, prices will generally be above GDP. However, during harsh bear markets such as the one in 2008, this ratio dips below 100%. (At 100%, total market valuations are equal to GDP.) These dips signify that the stock market had rapidly moved to being undervalued.

Investors can look up this indicator or calculate it themselves. Most people use the Wilshire 5000 Total Market Index as a proxy for total stock market capitalization. This index includes more stocks than any other index and holds high quality data on what they track.

As of this writing, the Buffett Indicator stands at 178%. It previously peaked at just above 200%. The indicator in fact has been on a steady upward march since 2013, when the indicator crossed the 100% threshold.

Criticisms

Common criticisms of the Buffett indicator are similar to those of the P/E ratio indicator. The indicator ignores the present ultra-low interest rates and the last decade-plus of quantitative easing (QE) policies.

The criticism works both ways. During the period of higher-than-normal interest rates in the 1970s and ’80s, the Buffett indicator dropped by more than half from near 100% to less than 50%. This is because bonds were, in many ways, a more attractive investment than equities during that period.

3. Tobin's Q

A lesser known metric that is comparable to the Buffett indicator is Tobin's Q. This indicator also looks at the ratio between business and the wider economy. Nobel laureate James Tobin created this indicator.

And the premise is simple: The combined market valuation of a stock market should roughly equal replacement costs. Replacement cost is the amount a business would have to pay to replace all of its assets. This ratio looks at the relationship between stock price and the value of the company's assets.

While this is straightforward when looking at an individual company, one can also apply this to the stock market as a whole by once again relying on the Wilshire Index and using the Federal Reserve's statistics on corporate balance sheets. The Fed statistics give investors a rough guideline as to the value of corporate assets in America. Dividing the market capitalization of the Wilshire Index by the asset value of corporations yields a Tobin's Q ratio for the entire market.

Reading the ratio is simple. A number below one means the market is undervalued. A number higher than one points to an overvalued market. And a ratio of one means the market is valued fairly; the market's price is equal to its underlying assets.

Criticisms

There are of course drawbacks to this metric. For example, most businesses — and indeed the market itself — trades at a premium to the underlying assets because the market also looks at the earnings the company can generate using its assets.

This means that a number over one can be harder to discern. However if the market is below one, that would be a clear indication of undervaluation.

Another particular concern is the ratio's focus on assets. As we all know, the largest businesses today aren't asset-heavy industrial giants, but rather software companies whose assets are more intangible and thus harder to value accurately.

Diversify your portfolio by investing in art

When it comes to investing, a diversified portfolio can lead to better returns. Masterworks' art investing platform has turned a previously inaccessible asset class into an actual option for individual investors. Think of artists like Banksy, Monet or Warhol. Get priority access and skip the waitlist here.

Skip the waitlist

4. The Inverted Yield Curve

Another widely followed indicator relies on the yield curve of government bonds. This alone will not tell you if a stock market is under- or over-valued. But it can tell you when a recession is looming. As a general rule of thumb, recessions are much more likely to occur after a prolonged period of overvaluation.

This recession indicator is the inverted yield curve. Inverted yield curves are rare because they defy traditional financial logic. An inverted yield curve occurs when the yield of a longer-term bond drops below the yield on short-term bonds.

During normal times, bond yields slope up for longer-term bonds. An inversion occurs when market participants en masse sell out of their short-term bonds and pile into longer-term bonds. Yields are inversely correlated to bond prices. So as long-term bond prices go up, their yields fall.

Why would this happen? Generally, if investors become concerned that an economic crisis is emerging, they pile into long-term bonds. To obtain cash, they sell either their equities or their short-term bonds.

They buy long-term bonds for two reasons. First, long-term bonds tend to not only maintain their value during economic downturns but actually appreciate as people buy more of them. And second, if an economic downturn begins, the Federal Reserve traditionally lowers rates. This lower interest rate benefits long-term bonds far more than shorter-term bonds.

As mentioned above, this indicator isn't something you can pop open any day and measure. It can, however, brace investors for possible turbulence. And it indicates possible peaks. For reference, the inverted yield curve has predicted the last seven recessions!

5. The Margin Debt

Our last indicator looks at the level of margin debt in the stock market. This indicator looks at an investor psychology that is far more common at peaks than at bottoms.

Investors borrow money on margin in order to buy more stocks. Brokers essentially offer a loan to investors to potentially increase their returns. But such loans also magnify their losses in a market downturn.

Margin debt is useful because as bull markets reach a stage of euphoria and stock prices start rising faster and faster, investors begin feeling like they have missed the boat (otherwise known as “fear of missing out,” or FOMO). In order to catch up with the trend or because they believe that the market will keep going up, investors engage in leverage far more liberally than during normal times.

This leveraged buying of shares of course causes stock prices to rise even more and sucks even more investors into feelings of FOMO. This cycle, which we have seen multiple times, continues until buying slows down and stock prices take a temporary dip. Because so many investors are now leveraged, this dip puts them at risk of a margin call (when the broker recalls the loan). And this forces investors to sell. Just as their leveraged buying pushed prices higher rapidly, their leverage-forced selling drops stock prices just as fast if not faster.

While not as scientific as other indicators, one should keep an eye out for just how much margin debt is being used, to determine whether it is reaching a new high. Leverage is used at periods of overvaluation, not undervaluation.

More: What is a margin call?

How to know when to invest in the stock market

When it comes to when it is best to invest in the stock market, the historical data is clear. If you invest when markets are overvalued compared to their long-term average, your forward returns will likely underperform.

But this is a simplified way of looking at it, since this so-called “value” approach has actually underperformed the market for the last decade. That's why it's important to take these indicators as tools and not binary buy/sell triggers.

For the reasons above, investors shouldn't think that they can time the market using very broad stock market indicators. Instead, you can use them to fine-tune your portfolio decisions.

If all the indicators show that markets are overvalued, we're not going to tell you to sell out your entire portfolio. Instead consider dollar-cost averaging instead of investing a lump sum. Conversely, if all the indicators are showing an undervalued market, maybe investing in one lump sum makes more sense.

More: What is dollar-cost averaging?

The bottom line

There are a few methods that investors use to figure out if the stock market is under- or over-valued. None of them however are a foolproof method of determining where the market is headed.

As an investor, it's a good idea to keep an eye on these indicators, especially if you plan to invest a large sum of money. And remember that stock market ups and downs are all a normal part of investing.

More: How to find undervalued stocks