Three Signals Indicate That the Stock Market is Overvalued

The American stock market could be historically overvalued. Experts, ranging from investment bankers to hedge fund investors, are raising concerns that stocks prices on the S&P 500 do not fully reflect the chaotic state of the nation’s economy and its bleak prospects for a post-COVID world.

Three indicators seem to signal this overvaluation clearer than ever. 

Correlations
Analysts at JPMorgan Chase & Co. have been tracking correlations between 30 asset classes across the world. These assets, ranging from convertible bonds, commodities and emerging-market shares, tend to have unique features and move independently. However, when assets move in lock-step, a phenomenon known as high correlation, experts believe it indicates indiscriminate buying and could signal overvaluation. 

This month, asset correlations hit their highest level since the year 2000. The last time correlations were this high, the dot-com bubble was at its peak. JP Morgan analysts believe the indicator is signaling another such bubble for the S&P 500 now. 

Buffett Indicator
Warren Buffett’s favorite stock market valuation indicator is also signaling a bubble. Buffett believes a nation’s stock market should be worth less the value of its annual gross domestic product. At the moment, the S&P 500 is worth a jaw-dropping 48% more than the U.S. GDP. 

Forward price-to-earnings
Appaloosa Management founder David Tepper has been following a metric that is commonly used for individual stocks to measure the S&P 500’s valuation. His estimates suggest that the market’s forward price-to-earnings ratio is above 20, a level not seen since 2002. “The market is by anybody’s standard pretty full,” Tepper told CNBC recently. 

While the stock market continues to move skyward, the economy has been compressed by the ongoing pandemic and widespread shutdowns. This disconnection has widened the gap between stock prices and their underlying fundamentals.