After years of inflating asset prices and pumping up stocks, the Fed is finally taking away the QE punch bowl…
The stock market may have made many investors rich over the last few years, but how much of it was actually real?
Sure, when the S&P 500 plunged to a record low of 666.79 on March 6, 2009, savvy investors knew that stocks were ridiculously cheap and that closing your eyes and throwing a dart on the board would probably yield AT LEAST some positive returns.
But the Federal Reserve and its massive quantitative easing program have undoubtedly influenced the returns we’ve seen to date.
An environment of low interest rates and low inflation has helped to inflate stocks and real estate – making many investors rich in the process.
Of course, a rising tide raises all boats. And as people made more money, investors that were sitting on the sidelines began piling in – further inflating asset prices.
But now that the economy is growing at a clip of about 1.9%, and unemployment is down to about 6.1%, the Fed has decided to gradually wind down its QE program by reducing bond purchases.
In fact, most economists think the first increase in the Fed’s short-term rate will happen in mid-2015.
Does this mean that the party’s over?
Should investors get out of stocks while they still can?
To answer this question, we must take a look at where the markets stand.
One good indicator of value is the Market Cap to GDP Valuation.
According to legendary investor Warren Buffett, the percentage of total market cap (TMC) relative to the US GNP is “probably the best single measure of where valuations stand at any given moment.”
A ratio of between 75% and 90% usually means the market is fairly valued.
Below 75% is undervalued and over 90% is overvalued.
As of today, the Total Market Index is at $ 21160.7 billion.
That’s about 124.4% of the last reported GDP.
But let’s not throw all of our eggs into one basket.
Another good indicator of value is the cyclically adjusted price-to-earnings ratio, otherwise known as CAPE, Shiller P/E, or P/E 10 ratio.
Prof. Robert Shiller of Yale and John Y. Campbell of Harvard invented the ratio over 25 years ago to measure the market’s valuation.
In Prof. Shiller’s words, here’s how it works:
Using inflation-adjusted figures, we divide stock prices by corporate earnings averaged over the preceding 10 years. Our ratio differs from a conventional price-to-earnings ratio in that it uses 10 years, rather than one year, in the denominator. It does so to help minimize effects of business-cycle fluctuations, and it’s helpful in comparing valuations over long horizons.
The CAPE ratio for the 20th century averaged 15.21.
Today, the CAPE ratio is above 25.
The only other times the CAPE ratio rose to these levels were in the years clustered around 1929, 1999 and 2007. As you can probably tell, we’re talking about the Great Depression, the Tech Bubble, and the Great Recession.
Again… not good.
What this exercise tells us is that today, stocks are not only overvalued – they’re nosebleed expensive.
In times like this, I urge readers to seriously reevaluate and scrutinize their holdings and to proceed with extreme caution.
Stocks that have skyrocketed beyond their fair values should be cashed in. So-called “fairly valued” stocks should be viewed with concern.
Even rare “undervalued” stocks have the potential to slide further – although with these gems, I would certainly take advantage of future dips to load up on more.
A healthy and long overdue correction could be on the way.
Let’s be ready for it when it comes.