I was recently asked two things: how do I pick stocks and how do I determine whether the stocks I want to buy (and the stock market as a whole) is over-valuated. It is the latest question I want to cover today. This may help beginners investing in the stock market. I bring you an extensive, yet simple (but profound) article, with metrics to assess the stock market. You simply have to connect when did stock market crash and what were the metrics telling you and you’ll probably find yourself making grounded stock market predictions.
In this post, I am compiling the indicators the literature points to to determine whether the stock market is over-valuated. I personally use 4 different metrics, which I explain in this post.
The current cycle
The economy works in cycles. The best source I’ve seen to explain the economy and how it works was this youtube video:
If you watch the entire video, you’ll learn that the economy works in cycles, and there are two particular cycles: the long-term and the short-term debt cycles. Debt and lending pretty much determine where we are going next. Transactions are the basic unit of one economy.
Note that the overwhelming majority of people cannot typically determine where they are, as they see the cycles too up close. If we are able to step back and determine where we are going, that will play in your favor in predicting the value of the stock market. Figuring out whether we are at the end of a cycle ain’t trivial, though.
We are currently in the second longest bull market of modern financial history:
Of course that this per se does not mean it will crash tomorrow, but we are almost certainly away from the beginning of the cycle if we consider history.
Total market cap compared to GDP
Market cap to GDP is Warren Buffett’s favorite metric, as he remarked in a Fortune Magazine interview that “it is probably the best single measure of where valuations stand at any given moment.” For real data with this indicator, I refer you guys to this article.
Put simply, this metric compares how much money companies are making compared to how much money people are investing in stocks. In most previous recessions, this metric has been above 1 (meaning that the total market cap has been larger than GDP), if we consider the Wilshire 5000 Full Cap Price Index as the market cap:
On, you can check out the current total market index (24.3 trillion, as of Feb 13th) and the last GDP in the US (18.9 trillion, as of Feb. 13th). This source also says that, according to this index, the stock market is significantly overvalued; based on the historical ratio of total market cap over GDP (currently at 128.6%).
The Inverted Yield Curve
The US government issues bonds (called Treasuries), which it has to pay back in quickly or in the long haul (e.g. 30 years). The funny thing is that sometimes the “long treasuries” pay less (per year) than the “short ones”.
If we have a look at these charts, you’ll find out that sometimes the “long treasuries” start paying less than the “short ones”; When this happens, a recession (or market crash) may be just about to come to be:
I recently started to use this metric, which I learned from John Roberson. Thank you, John!
And finally, my favorite:
Household debt as a percent of GDP
The household debt as a percent of GDPis the ratio of a country’s debt to its GPD. Put simply, this compares what a country (as a sum of its households) owes to what it produces. If this is too high, this means that the ability of that country to pay back its debt is reduced.
When credit is at its top, the disposable income of families is high (if you think about the economy as a sum of transactions, it is indeed quite simple to understand). The following chart may provide some data on this, but unless the other metrics, there has been little to none correlation between one value for household debt and an actual crash:
You can check out real-time data for this metric here.
You may use this data to your favor, as I am using to mine. Be prudent and look at the evidence. If you think it is the time go out there and look for good stocks to buy. If not, hold still and keep reading my blog 🙂