In recent posts, I have made the case for why U.S. equities are not in a bubble, noting that valuations are still far from past peaks.
That said, given the relentless rise in U.S. stocks, it’s hard to argue with the fact that certain market indicators, including a few valuation metrics, are flashing yellow.
To gauge when (and if) the market has officially tilted into bubble territory, I would suggest that investors focus on two sets of data: valuation and sentiment.
- Valuation. My main argument against a bubble in U.S. equities is that while valuations are no longer cheap, they are a far cry from previous peaks. However, some measures – notably the Tobin Q Ratio, gross domestic product (GDP) to market capitalization, and the Cyclically Adjusted P/E – are high, arguably too high.
I would pay particular attention to the Shiller P/E Ratio, which is a variation on the Cyclically Adjusted P/E or CAPE. This indicator is worth watching as it has historically correlated with long-term stock market returns. Today’s reading, in the mid 20s, suggests below average returns in coming years. A further advance would suggest a more serious problem. By way of comparison, the indicator reached a high of around 30 prior to the 1929 crash and was close to 45 in 2000.
2. Sentiment. While valuation is important, investors should also pay attention to sentiment. The goal is to gauge how – to steal a phrase – “irrationally exuberant” investors have become. In measuring sentiment, investors should focus on two types of indicators: what are investors doing and what are they thinking.
While there are dozens of different indicators, I’ll focus on two: put/call ratios and Bullish/Bearish Sentiment. The put/call ratio is a short-hand proxy for positioning among options traders. Lower readings correlate with more bullishness. The ratio was 0.48 at the end of November. While this is modestly below average, it is a far cry from the lows of early 2000. In other words, options investors are positioned bullishly, but not excessively so.