Are we in a stock market bubble and just haven't realized it yet?
The stock market continues to advance. To a certain degree it seems to make sense. After all, quite a bit of positive economic news has been coming out as of late - why not invest?, why not get a take a little more exposure to the stock market? Why not ? - Because of valuation. Valuation has shown to rule the day in the end no matter how good the news.
Most stocks have years of historically trading within a certain valuation range - a range of different financial ratios. Whether its Price/Earnings , Price/Sales, Price/Book ratios, among others, the stock reliably moves within a particular range for a given stock.
If an investor keeps track of where stocks typically are within this range, it can provide a lot of insight as to where stocks are from a valuation point of view. Are more stocks, or an individual stock, trading near the high or low range of these bands? At gmcstockpicks.com we look at and rank stock valuations on a historical and projected earnings basis for the 1,500 largest stocks.
Why the largest 1,500 stocks? Well the 1,500 largest stocks represents around 70% of the entire US stock market value and are also reliably followed by analysts. Since analysts typically follow these stocks, there has been some professional level of effort at projecting earnings over the next one to two years. Believe me, talking from someone with experience - calculation of that single number - earnings per share is A LOT OF WORK. When an analyst takes a crack at it - perfect or not - unless you have years of specific industry experience (when following the Peter Lynch "invest in what you know" adage) - it’s a better use of your time to go with their numbers. Often time, publicly, you'll find the average of several analysts earnings per share estimates anyway.
Specifically, we compare the number of opportunities that have the potential to appreciate 10% or more and we compare this to the number of stocks that have the potential to decline 10% or more. As we track this relationship from week-to-week we get a good feel whether stocks are becoming more overvalued or more undervalued.
We found continuation of a trend from a few weeks ago. At the end of last week we now found twice as many overvalued stocks as there are undervalued stocks - not a good sign for buying stocks. Either stocks are simply becoming overvalued (recent market advances) or projected earning estimates are declining or both.
I'm sure you didn't hear it here first - but monitor the market closely. Furthermore, volume has been below average - historically a bearish sign. I'm not convinced that these recent advances in the stock market are justified and sustainable in the near term. The near term profit opportunity looks to be to short some overvalued stocks or purchase some put options on a market index.
Look out - the valuation figures speak for themselves. A bubble looks like its here. How much bigger it gets remains to be seen. Let's hope we can avoid a bubble burst and worse case scenario just experience a slow orderly leak.