Three rough stock market timing tools: what are they saying?

Long ideas are hard to come by, and I don’t want to discuss any more short ideas in this newsletter. I’ve been looking for investment candidates, and while some seem attractive, they are either very small or expensive. So, I decided to do a macro-article this month to examine if overall markets were overvalued – here is my analysis:

Navigating the stock market can feel like being adrift in an unpredictable sea. Even seasoned investors, who’ve dedicated years to studying market trends, admit that predicting what will happen next is nearly impossible. Warren Buffett, one of the most respected voices in investing, famously said, “We haven’t the faintest idea what the stock market is gonna do when it opens on Monday—we never have.”

However, while precise predictions are out of reach, that doesn’t mean we’re left entirely in the dark. Certain indicators, or "rough timing tools," can give us a general sense of whether the market is overvalued or undervalued. These tools won’t offer exact answers, but they can help us make more informed decisions by identifying broad trends and potential risks. Two such tools are the Buffett Indicator and CAPE-10, which provide valuable insight into market valuation and help investors assess their positions.

The Buffett Indicator: Gauging Market Size Against the Economy

One widely referenced tool is the Buffett Indicator, named after Warren Buffett himself. This indicator measures the market’s total value to the economy by dividing the total market value of all publicly traded stocks in a country by that country’s Gross Domestic Product (GDP). Buffett has called it “probably the best single measure of where valuations stand at any given moment,” which has made it particularly popular.

In the U.S., the Wilshire 5000 index is often used to represent the total value of the stock. When we divide this value by the country’s GDP, we get a sense of whether the market is overvalued or undervalued relative to the economy. Historically, a ratio above 100% is considered high, indicating the market might be overvalued. Currently, the Buffett Indicator for the U.S. sits at around 209%, an exceptionally high figure, which suggests that future returns may not be as strong as they have been historically. While sobering, it’s essential to remember that this indicator is only one of many tools investors can use.

CAPE-10: Looking to History for Perspective

Another popular tool for gauging market valuation is the CAPE-10, or the Cyclically Adjusted Price-to-Earnings Ratio, which economist Robert Shiller popularized. Unlike the standard P/E ratio, the CAPE-10 takes a ten-year average of earnings, smoothing out short-term fluctuations and providing a broader view of market valuation over time.

The appeal of CAPE-10 lies in its ability to give historical context. Investors can gain insight into possible future outcomes by examining periods when the CAPE-10 was at similar levels, echoing Mark Twain’s words, “History doesn’t repeat itself, but it often rhymes.” Currently (October 3rd), the CAPE-10 is at a notably high level of 36.32. Historically, when CAPE-10 has been at similar levels, subsequent 10-year returns have ranged from -4% to 4%. Like the Buffett Indicator, this high CAPE-10 level suggests that the market may be overpriced, signaling caution.

The Hypothetical Index: A New Model for Market Timing

In addition to traditional indicators, I’ve developed a hypothetical index inspired by my readings on PhilosophicalEconomics.com, a blog I highly recommend for its in-depth perspectives on finance and investing. This hypothetical index combines multiple factors—earnings growth, valuation, cyclicality, and volatility—to create a broader framework for assessing the market’s position.

The index begins with two fundamental building blocks: earnings growth and the Price-to-Earnings (P/E) ratio. Historically, U.S. companies’ earnings have grown at an average rate of about 6% per year, providing a solid baseline for the index. Using a P/E ratio of 16, which translates to a 6.25% yield, the index builds from this historical average valuation.

However, markets are not linear—they move in cycles. To capture this cyclical nature, the index includes a sine wave component representing a typical seven-year market cycle with a 25% deviation. This cyclicality reflects the market’s natural rhythm of highs and lows, which are often driven by broader economic trends, investor sentiment, and external events.

To address volatility, the index creates a band or range within which the market can fluctuate, representing the extremes of possible market behavior. This approach enables the index to capture both the cyclical and volatile nature of the stock market, providing a more comprehensive view than traditional tools alone.

The practical benefit of this hypothetical index is that it can help investors make informed decisions by signaling potential buying or selling opportunities. For example, if the S&P 500 rises well above the index’s upper limit, it might indicate overvaluation, suggesting it’s time to consider reducing stock exposure. Conversely, if the S&P 500 falls below the index’s lower bound, it could signal undervaluation, presenting a potential buying opportunity.

Currently, the S&P 500 is at the upper end of the index’s limit, which signals caution. Historically, such occurrences have resulted in a market correction.

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A Holistic Approach: The Hypothetical Index vs. Traditional Indicators

Traditional tools like the Buffett Indicator and CAPE-10 are widely respected and valuable. They focus on specific aspects of the market—valuation and long-term earnings trends. However, the hypothetical index offers a more holistic approach by incorporating growth, valuation, cyclicality, and volatility, making it a versatile tool for understanding market movements beyond just valuation.

In summary, while no tool can predict the future, combining traditional indicators like the Buffett Indicator and CAPE-10 with the hypothetical index provides a well-rounded framework for market timing. Together, these tools offer a deeper understanding of where the market might stand relative to its historical averages, enabling investors to approach their decisions with greater confidence and clarity. Currently, all three indicators are signaling caution, each suggesting that the S&P 500 is overvalued. Given these warnings, approaching the stock market with caution is wise.