How Could Stocks Be So Greatly Overpriced?

Bears say stocks are 73% overpriced. Bears have been bearish for several years while stocks have continued to rise a lot. Does that mean the bears are wrong? In the 1998-2000 bubble bearish advisors were three or four years early in calling for a crash. But what about the claim that stocks are 73% overpriced today. How could investors make such a mistake?

Investors overpaid for tech stocks that crashed 95% to 99% in the dotcom bubble of 2000. So if today’s overpriced stocks are going to revert to fair value of roughly 1135 for the SP from a 73% overpricing then that would be a price drop of 42%. However during a crash prices overshoot their downside target by 20% so perhaps the SP will briefly go to as low as 900, which would be a 52% drop. (The SP is now at 1936).

One way to visualize how people can make financial mistakes is to look at the tremendous increase in all types of debt (corporate, personal, and government). The debt to GDP ratio was at 180% during the prosperous 1920’s, went way up due to the 1929 crash because GDP went down, then stayed very low in the 120% to 160% range due to the trauma of the Great Depression where people became reluctant to borrow. Once the population became too old to remember the Depression then in 1985 the ratio began to go parabolic and went above 180%. This level is the average of the past 143 years and is a good benchmark because it was the debt level of the 1920’s when people were prosperous but were not as indebted as in modern times.

Someone could argue that increased debts were needed in the 1980’s as part of Cold War defense spending and due to the growth of two-income Baby Boom age group couples buying homes. But at some point those reasons for increased debt needed to stop. The current debt ratio is 345% which is 1.92 times the ratio when it crossed out of reasonable territory and went parabolic. This is an increase of 2.5% a year over the past 27 years. Since the ratio of debt to GDP includes adjustments for growth of the economy (partly a proxy for population growth) and inflation then the debt increased by roughly 2.5% a year for inflation, another 2.1% for real GDP growth and then another 2.5% faster than real GDP. These little annual incremental increases are modest if looked at only in the context of one year, but using the power of compounding they have increased the debt ratio from a reasonable 180% to a crazy 345% in 27 years. Assuming the debt increase was used to buy stocks that would help to explain why stocks are overpriced. In 1987 the SP traded between 247 to 323. With the growth of the economy the SP fair value today should be at roughly 1135 or 1200 depending on what models one uses. Perhaps the 1.92 fold increase in debt in excess of reasonable ratios explains why stocks become so high priced.

It has been alleged by critics of the PE10 ratio that this ratio hasn’t worked because much of the past 17 years stocks prices and PE’s have been too high according to the PE10 rule. But the past 25 years or so have been a new era in history like never before where massive amounts of global and domestic debt have been issued. People get unsolicited invitations to apply for a credit card loan with a one year no interest loan and low fees. They see this as “free” money and use it to buy stocks. Then they get a margin loan from a stock broker and pull cash out of the account and move it to another broker and buy more stocks on margin.

It is interesting that debt ratios went parabolic in 1985 when “Easy Qualifier” home loans (Liar’s Loans) were invented. That was also the start of a new, unprecedented era of easy lending.

Instead of each person borrowing an extra 2.5% a year more than he would have otherwise done at a more prudent level, perhaps the excess debt was generated because a tenth of the population borrowed 25% too much each year, perhaps to speculate in stocks or to have a bidding war during a housing boom. One average if 10% of the people borrow an extra 25% that’s an extra 2.5% increase a year over the normal amount of increased debt.

As population increases so does the GDP and the legitimate need to borrow. The same applies for inflation. However when the ratio of debt to GDP goes parabolic as it did in the 1980’s and stays high for 27 years then surely one must at least wonder would this lead to stock bubble?

The home sellers had to put their new found cash somewhere, so they put it into stocks, causing a bubble.

Investors need independent financial advice about stock market bubbles. I wrote an article “Stock bubble increase is like debt compounding”.


About the author

Don Martin, CFP®

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