Evaluating the current state of the U.S. equity market reveals that valuations sit at notably high thresholds by multiple metrics. The widely tracked S&P 500 index trades near a price-to-earnings ratio of 31, a valuation multiple reached during limited intervals since the late 19th century. Another long-term gauge, the Shiller cyclically adjusted price-earnings (CAPE) ratio, which averages inflation-adjusted earnings over the preceding decade, recently ascended to 40. Historical data shows this figure was previously attained only during exceptional market exuberance such as the peak of the dot-com bubble.
Among valuation measures, the Buffett Indicator commands significant attention. Named after Warren Buffett, who has described it as arguably the most effective single barometer of market valuation, this ratio reflects the total market capitalization of U.S. equities against the gross domestic product. It essentially attempts to quantify the stock market's size relative to the economy supporting it.
Historically, this indicator has fluctuated mainly within a band from approximately 40% to 100%. The ratio first breached the 100% level in the late 1990s during the buildup to the technology sector bubble. After passing through subsequent volatile periods, including the financial crisis years, the Buffet Indicator has continued its trajectory upward, setting new records.
Currently, the Buffett Indicator's value stands around 230%, an unprecedented high point roughly 77% above its long-term average trend. This mark not only signifies that the market's valuation relative to GDP is at an extreme absolute level but also that it is positioned two standard deviations above its historical mean. Historically, readings at or above this threshold have occurred just three times in the preceding 60 years.
These previous instances have preceded significant market setbacks. For example:
- Late 1960s: The S&P 500 reached new highs by 1968; concurrently, the Buffett Indicator signaled an extreme valuation. This event prefigured a bear market with the index declining over 30% by 1970 and nearly 50% by the mid-1970s amidst a stagflationary environment.
- 2000 Technology Bubble: After peaking in March, the S&P 500 contracted approximately 40% through October 2001, coinciding with highly elevated valuation measures. The price-to-earnings ratio at the peak was slightly above 30, aligning closely to current levels.
- 2021-2022 Period: Following the recovery from the COVID-19-induced downturn, facilitated by low interest rates and substantial fiscal stimulus, the market experienced a roughly 25% decline by late 2022 as inflation surged and economic conditions shifted.
It's important to note that while current valuations indicate a stretched market based on this gauge, this does not imply an imminent bear market or certainty that valuations cannot climb further. Instead, the elevated Buffett Indicator suggests that future market returns may be muted compared to previous years and that volatility could become more pronounced intermittently.
Comparatively, the current environment differs somewhat from the speculative excesses of the 2000 bubble when speculative pricing dominated unprofitable companies. At present, earnings growth continues to provide some foundation for elevated valuations, although sustainability remains uncertain.
In conclusion, while favorable macroeconomic conditions may offer some support to equity valuations, the historically elevated Buffett Indicator serves as a cautionary signal. Investors should be cognizant that, historically, similarly high valuation levels have been precursors to notable market corrections and extended periods of below-average returns.