The stock market has never been this big relative to the economy, signaling it could be overvalued

The size of the stock market relative to the size of the economy is at its highest level ever, raising concerns that the market’s recent all time highs are detached from reality.

The likes of legendary investors Warren Buffett and Paul Tudor Jones have measured the stock market in this, or similar ways in the past to determine if it is overvalued or undervalued.

While some valuation measures are based on fickle analyst estimates, the equity market cap-to-GDP ratio is based on concrete and simple data. The same goes for Buffett’s reportedly preferred gauge, equity market cap-to-gross national product, and the Nobel Prize winner Robert Shiller-created cyclically-adjusted price-to-earnings ratio (CAPE). CAPE, the ratio of the stock market to historical earnings, is near the highest since the dotcom bubble.

These big picture looks at economic health are basically showing investors are unrealistically valuing future growth.

The equity market cap-to-GDP ratio is at an all-time high, above 200%, Goldman Sachs noted to clients last week. With the S&P 500 up more than 1% in 2020, following a near 30% rally last year, stocks are more expensive by historic standards. The ratio measures the value of all public companies and divides it by U.S. GDP.

The chart is similar to one Buffett said he watches as a key measure of valuation, calling it “probably the best single measure of where valuations stand at any given moment” in a Fortune magazine article in 2001. The Oracle of Omaha said he likes the market cap-to-GNP ratio to be around 70% to 80% — it sits around 187%, by CNBC’s calculations.

Hedge fund manager Tudor Jones also reportedly watches a variant of the Buffett gauge. Back in 2017, PTJ said the market’s value relative to the economy should be “terrifying” to the Janet Yellen-led Federal Reserve due to low interest rates. The Fed later hiked rates three times in 2017, two times after PJT’s comments. Ultimately the central bank got the warning and reversed itself, cutting rates three times last year helping the economy to catch up.

Shiller’s measure

CAPE is near the highest since the 2000 dotcom bubble, when internet stocks rose and eventually collapsed, shedding nearly 80% of value within seven months. The CAPE ratio is a measure that compares stock valuations from different eras by averaging earnings over ten years, eliminating some of the short-term volatility of each market cycle.

Currently, CAPE sits around 28, in the 90th percentile, which Shiller called “significant” in a New York Times article this year. To be sure, it was slightly higher in September 2018, a period that preceded a significant market sell-off.

High valuations, low earnings growth

Such remarkable gains in 2019 have left U.S. stocks expensive — in the 10th decile, meaning equities have been cheaper at least 90% of the time.

“Such elevated valuations in past periods have weighed on equity returns over the subsequent five years and lowered the odds of positive outcomes,” Goldman Sachs Investment Strategy Group CIO Sharmin Mossavar-Rahmani said in the group’s 2020 outlook. “That the bulk of last year’s returns came from higher valuations, and not growth in earnings, only compounds investors’ concerns.”

Low rates make it OK?

Some economists and traders attribute low interest rates instituted by central bankers around the world for the high valuations and maintain they should allow for higher PEs without big cause for concern. However, Shiller noted interest rate levels historically do not correlate with the CAPE ratio.

Stocks continue to climb to all-time record highs and seem to disregard geopolitical pressures. Shiller attributes “animal spirits,” a sense of optimism and inclination toward risk to the gains.

“High animal spirits in the stock market are often associated with the disparagement of traditional authority and expert opinion,” Shiller wrote, which he said is being inspired by President Donald Trump’s Make America Great Again narrative.

“The rise of an explicit belief in irrationality like this one is troubling on many levels,” Shiller wrote in the NY Times.

— with reporting from CNBC’s Nate Rattner and Michael Bloom.

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