Warren Buffet's Yardstick
Back in 2001, when Warren Buffet first introduced this chart, he wrote that "it is probably the best single measure of where valuations stand at any given moment". The argument is that stock market valuations cannot deviate too far from the size of the economy. Right now, the chart suggests US equities are heavily overvalued.
S&P P/E Ratio
The price-to-earnings ratio (P/E ratio) measures the price of a share relative to the earnings per share (EPS). It indicates investor optimism towards future earnings. A high value implies share prices have risen more than recent or soon-to-be-released earnings. This could mean that stock markets expect future earnings to rise significantly or that stock prices have deviated from fundamentals (earnings) and are overvalued. Recently, the P/E ratio has been falling from elevated levels, suggesting valuations are less stretched than before.
Volume of Speculation
A rise in borrowing or margin finance to invest in stocks can be a tell-tale sign of a market bubble. One reason is that any setback in market prices can quickly lead to brokers demanding repayment of loans – that is, margin calls. This can lead to cascading sales and sharp market drops. Currently, margin debt is at record highs, which is worrying for stock markets.
Growth vs Value Stocks
Value stocks typically have low P/E ratios and high dividend yields. These are unloved stocks that offer solid fundamentals. They typically outperform during bear markets and economic recessions. In contrast, growth stocks come with opposite characteristics – high P/E ratios and low or no dividends. These are glamorous stocks that typically outperform in bull markets. In our chart, we divide the Wilshire US Large-Cap Growth Index by the Wilshire US Large-Cap Value Index. The ratio is currently high, though not as high as the late 1990s. Nevertheless, it shows that growth stocks have significantly outperformed value stocks. Could now be the time for value to shine?
US vs RoW Equities
US equities have consistently outperformed the rest of the world since the Global Financial Crisis of 2008. This is the longest period of outperformance in modern history. A big reason is the presence of the world’s top tech companies in the US stock index. Therefore, any hint of their dominance ending could see the US:world ratio turn around.
Stocks to Real Estate Ratio
Real estate and stocks are typically the largest sources of wealth for households. In general, stocks have outperformed real estate. But there have been notable periods of real estate outperformance, such as during the 2000s. Since the Global Financial Crisis of 2008, stocks have clearly outperformed real estate. Worryingly, stocks are now trading at a higher multiple of real estate than seen even during the dot-com phase in the 1990s.
Home Price to Income
Before the Global Financial Crisis, US house prices averaged five times the average US income. But during the housing bubble of 2006, the ratio reached seven. Currently, it is even higher at almost 7.5. This suggests real estate is overvalued.
Real US Home Prices
Another way of assessing house prices is to compare them with CPI inflation. Over time, we would expect house prices to beat inflation – that is, real house prices should trend higher. However, we would be more cautious if real house prices sharply accelerated, which we have seen since COVID began in March 2020.
Bitcoin vs Gold
Bitcoin has been called "digital gold". So, comparing bitcoin to gold prices is natural. We can see some periods of significant Bitcoin outperformance such as during 2017 and just after COVID erupted in March 2020. These wild gyrations suggest Bitcoin is behaving less like gold than a high-risk technology stock. Recently, Bitcoin has been underperforming gold.