“In light of this interest rate backdrop, the question is whether stock prices have run too far ahead of fundamentals,” Ted Berg, an analyst at OFR, said in a report. “Although certain traditional valuation metrics, such as the market’s forward PE ratio, do not appear alarmingly high relative to historical averages, other metrics to be discussed — the cyclically adjusted PE ratio (“CAPE”), the Q-ratio, and the Buffett Indicator — are nearing extreme levels, defined as two standard deviations (or two-sigma) above historical means.”
At the end of 2014, the CAPE ratio, a valuation measure based on real-per-share earnings over a 10-year period, was in the 94th percentile of historical levels. The Q-Ratio, the market value of non-financial corporate equities divided by net worth, is also moving toward its two-sigma deviation – the last time it crossed the level, it quickly plunged following the dot.com crash. Lastly, the Buffett Indicator, a ratio of corporate market value to gross national product, is at its highest since 2000. [Inverse ETFs to Hedge a Bearish ‘Warren Buffett Indicator’]
Consequently, Berg warns of a large market price decline after a period of extreme valuations. Specifically, Berg points out that the market indicators are two-sigma above historical means, which typically occurs once every 40-plus years, but they occur more often in equity markets due to fat-tail distributions.
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Max Chen contributed to this article.