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US Stock Market Remains Significantly Overvalued

- By James Li

Several economic indicators, including the Buffett indicator and the Shiller price-earnings ratio, suggest the U.S. stock market is significantly overvalued as of Feb. 2, 2017. As the stock market valuations reach near a 10-year high, the U.S. market expects negative returns in the upcoming years.


Is Buffett becoming bearish on stocks?

A previous article suggested Warren Buffett (Trades, Portfolio) was bullish on stocks at the beginning of 2017. Although the Berkshire Hathaway Inc. (BRK-A) (BRK-B) CEO generally had over 50% of its assets in stock equities throughout the past 10 years, Buffett and Charlie Munger (Trades, Portfolio) have reduced their allocations in stocks from a 10-year high of 63% since 2013. Meanwhile, the co-managers increased their cash position from a 10-year low of 20% to its current value of 35%.

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Buffett claims the ratio of Wilshire 5000 over GNP is "probably the best single measure of where valuations stand at any given moment." The Buffett indicator is currently at 126.2%, close to a 10-year high. Based on this valuation level, the U.S. stock market is expected to return -0.4% a year including dividends.

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Based on the valuations for the previous two months, the dividend yield for companies trading on the Standard & Poor's 500 index decreased during January 2017. The Buffett indicator remained the same yet the expected annual return declined 0.1%, which likely represents the decline in dividend yield (1.98% as of Feb. 2 compared to 2.02% as of Jan. 3).

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Shiller P/E exceeds 70% over historical mean

Yale professor Robert Shiller measured stock and market valuations with a cyclically adjusted price-earnings ratio, defined as the price of a security divided by the inflation-adjusted earnings for the past 10 years. The market Shiller P/E is currently 28.5, about 70.7% higher than the historical mean of 16.7. Based on this valuation, the U.S. stock market is expected to lose 1.3% per year.

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A brief discussion of Economic Indicators and how they explain market valuations

As of Feb. 2, the GuruFocus Economic Data page contains historical charts on about 150 economic indicators, including the S&P 500 earnings per share, S&P 500 dividend yield and the Buffett indicator. You can access this page by clicking "Economic Data" under the "Market" tab. By default, you will see the historical chart of S&P 500 earnings per share.

Although the S&P 500 EPS gradually increased from 2010 to 2014, the earnings per share declined about 20% from its 10-year high of $110 since 2014. Decreasing earnings per share implies higher price-earnings ratios, which leads to higher market valuations. The lower earnings per share also decreases earnings yield, which have gradually declined since 2011.

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Incorporation of Economic Indicators in Interactive Charts

As discussed in the following tutorial article, the Interactive Charts feature allows you to generate illustrative figures on historical financial data, economic data and other miscellaneous "technical indicator" data. You can access Interactive Charts by clicking the "Interactive Chart" tab from a company's stock page or select "Interactive Chart" from the GuruFocus Search bar. The figure below shows a sample Interactive Chart that graphs the historical price of ExxonMobil Corp. (XOM) and the Crude Oil Prices: West Texas Intermediate index.

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For more information about the Interactive Charts feature, please refer to the user manual.

Conclusions

As the stock valuations reach near 10-year highs, the U.S. stock market faces moderate recession risk. Companies that offer good value for early 2017 should meet Buffett and Munger's four-criterion investing approach: high business predictability, expanding margins and revenue growth, low price-earnings to growth ratios and no meaningful debt. Allegiant Travel Co. (ALGT) meets most of the above criteria, and thus it is one of my strong stocks for 2017.

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Disclosure: I do not have any position in the companies mentioned.

This article first appeared on GuruFocus.