Are Stocks Strongly Overvalued? This Market Guru Says Yes


Robert Shiller is noted for many things. He's a Nobel laureate. He's one of the world's leading economists. He developed the Case-Shiller Index, which revolutionized the way we track real estate prices.

And, when the stock market was supernova hot on the heels of the boom in 2000, he predicted the bubble was about to burst.

We all know what happened next.

So what does Shiller have to say about today's stock market? Plenty -- and none of it reassuring.

Are stocks overvalued?

In Greek mythology, Cassandra was the daughter of the King of Troy. Fascinated by her beauty, Apollo gave her the power of prophecy.

Despite this gift, Cassandra wasn't interested in Apollo's romantic overtures. Stung by rejection, he cursed Cassandra, ensuring that nobody would believe her prophecies. Cassandra could see disaster coming, but was helpless to convince anyone of their impending doom. 

Robert Shiller is no Cassandra. When he speaks, markets listen. He's proven to have an uncanny knack for calling market tops.

In a recent media interview, Shiller didn't mince words, saying the market "looks a bit like a bubble again." Shiller noted that stock prices have tripled since 2009.

Shiller's famed Cyclically Adjusted Price Earnings Ratio (CAPE) is one way to measure overvaluation. Over the last century the average CAPE ratio in the U.S. is 17.

In July, it reached 27. That's a level that's rarely been topped. Here are three examples of an equally inflated CAPE: the market collapses of 1929, 2000 and 2007. 

So you can see why valuation concerns are prevalent.

These worrisome numbers have been accompanied by a general sense among investors that the market is overvalued. Shiller, after studying investor surveys, concluded that investor fear of overvaluation is higher today than it was in 2000. He believes the market could fall by as much as one-third.

Unfortunately for investors, Shiller concedes it is impossible to time any bubble pop. In 1998, we had a CAPE of 35. Some were convinced a bubble burst was imminent. Yet the market grew at a remarkable rate for another two years, before eventually crashing. We just can't predict with certainty when it's going to happen. We also can't predict how others (including the government) will react.

So what can we do?

Action Plan: How should I respond to overvaluation concerns?

There is strong evidence that stocks are valued too highly. There are also indications that investor confidence in market valuation has been dropping steadily for years. So what's the best approach for dealing with an overvalued environment?

  • Identify which stocks to avoid. Consider investing in small, value-priced stocks.
  • One good way to do this is to invest in ETFs that own small, value-priced stocks. iShares, Vanguard and other firms have offerings in this category.
  •  Resist the urge to overreact. Panic selling is often the worst thing you can do when a downturn begins.
  • Consider lowering your exposure to stocks with high volatility in favor of more defensive investments.
  • Study valuation measures. P/E to growth, P/E to sector and rate of dividend increase are highly useful metrics.
  • Consider moving into bonds, or other investments with low stock market correlation.
  • If you're feeling frisky, you can always short the market while going long on a high performing stock such as Apple. 

There are significant indications that the market may be overvalued. Yet that doesn't mean it's time to panic. Follow the steps outlined above to ensure you're in the best possible position to negotiate a market drop.

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