After the 2022 bear market, when the S&P 500 was down by about 19% and the Nasdaq Composite fell 33%, it appeared that the market had indeed corrected, with prices coming back down closer to their recent historical ranges.
After all, the markets had become historically overvalued in the post-pandemic run-up. The S&P 500 climbed 29%, 16% and 27% in each year between 2019 and 2021, and the Nasdaq gained 35%, 44% and 21% in those same years.
However, the markets have bounced back this year, with the S&P 500 up 18% and the Nasdaq up 36% year to date (YTD), led by the technology and communication services sectors, which are both up more than 50% YTD. That begs the question of whether the market has become overvalued again, particularly in the tech sector. Let’s take a look.
Two years since the Nasdaq’s high
The S&P 500 hit an all-time high of 4,797 on Jan. 3, 2022, and since then, it has dropped about 4.6% from that overinflated perch to around 4,547 on Nov. 21.
The Nasdaq hit its all-time closing high on Nov. 19, almost exactly two years to the day, closing at 16,057. Further, it hit its intraday all-time high of 16,212 on Nov. 22, 2019, as the bear market started earlier for technology stocks. Since then, the Nasdaq is down by about 12% to 14,284 as of Nov. 21.
However, when you consider the huge total returns that these benchmarks had leading up to those highs, the declines seem relatively small. Since the market opened on Jan. 2, 2019 at 2,477, the S&P 500 has gained 96% — or about 25% per year on an annualized basis — leading up to its January 2022 all-time high. The increase for the Nasdaq was even more dramatic, as it had risen 130% — or roughly 32% per year on an annualized basis — for the three years leading up to its November 2021 all-time high.
This just points out that the recent declines for these benchmarks are just small fractions compared to the gains they notched leading up to them.
Letʻs examine a key metric to see where valuations stand: the price-to-earnings (P/E) ratio.
Shiller P/E ratio still above normal
Just as the P/E ratio is broadly used to gauge the valuation of a stock, it is also used to measure the valuation of an index by looking at its stock price in relation to its earnings. If the average price is considerably higher than the average earnings, the index may be overvalued.
The P/E ratio looks at numbers over the trailing 12 months, while the forward P/E is based on projected earnings over the next 12 months. However, a more accurate measure may be the Shiller P/E ratio, also known as the cyclically adjusted price-to-earnings, or CAPE, ratio.
The Shiller P/E ratio, named after the man who developed it, economist Robert Shiller, looks at earnings over the previous 10 years. Also accounting for inflation, it’s designed to capture a long-term view of earnings power as opposed to a short-term snapshot.
Currently, the Shiller P/E ratio is about 30.7, which is still historically high. It is certainly lower than its recent high of 37.4 in June 2021 and down from 36.9 in December 2021, when the bubble started to burst. That was as high as it has ever been, other than during the dotcom bubble in 1999, when it hit 43.8. However, the current Shiller P/E ratio is up from 29 in June 2022.
Now what is normal? Over time, the mean Shiller P/E ratio is 17, but that is going back more than 100 years. If you look at the past 20 or so years, the average is in the 25-to-26 range, with the low being about 13 in 2009. From 2010 through about 2016, it stayed mostly within the 20-to-25 range, but since then, it has mostly been above 26, except for when the pandemic bear market hit in 2020, and it dropped to 24.8. However, in late 2021 and early 2022, the Shiller P/E ratio was in the 36-to-38 range, and the market dropped precipitously soon after.
For additional context, the regular P/E ratio is currently at around 25, which is higher than it was in January 2022, when it sat at 23, but far less than the 39 reading it hit in December 2020. Over the past 20 years, the Shiller P/E raio’s average range seems to be in the high teens to low 20s.
Where are we now?
All these numbers suggest that the market is still overvalued but not near the levels seen during the 2021 technology bubble. That, in turn, could suggest that these major indexes will come back a bit in 2024 or perhaps have low growth, which many analysts are predicting.
As for investors, they should keep an eye on valuations. Just because an index may be a bit overvalued does not mean that all stocks in it are too. However, if the P/E ratio for an individual stock is well out of its normal range, it may be overvalued.
Additionally, the S&P 500 and Nasdaq focus on large caps and technology stocks, so be sure to broaden your portfolio to include small and mid caps and value stocks.