Is the Stock Market Overvalued?
Spoiler Alert: Nobody knows
Is the stock market overvalued? As of this writing the S&P500 stock price index stands at a value of about 5968. That is just below the all-time high of 6090, which occurred only two weeks ago on December 6th. Whenever the stock market hits “all-time highs,” talk of stocks being “overvalued” becomes all the rage. So, is the stock market overvalued?
First though, a couple of preliminary questions:
What the heck does it even mean for the stock market to be overvalued?
And, for that matter, what is the stock market?
What is this “market” you speak of, sir?
Generally speaking “the stock market” refers to the buying and selling of stock shares, shares which confer ownership in any number of publicly traded companies. What is a publicly traded company?
A publicly traded company refers to a company that was once started by an individual or a group of individuals, but then grew large enough that the founders decided to turn over ownership of that company to public shareholders. To do so, said founders invite any person to buy a “share” of ownership into that company. That is what owning a stock means, you own a small slice of that company.
In practice, when “taking the company public” the founders will be allocated most of the shares of the company, so that they retain control of the company. But, when the profits of that company increase, or the price of those shares increase, those that owns shares of stock in that company also benefit, not just the founders.
When a company decides to “go public” and issue shares, they also decide on which trading platform those shares will be traded.1 The New York Stock Exchange or the Nasdaq exchange are examples of “exchanges”. These venues are locations (electronic now, in person in days of yore) where stocks “are brought to market” to be bought and sold.
Hence, the “stock market” consists of the entire universe of shares in publicly traded companies, regardless of the exchange on which they are traded. Yet, that entire universe of stocks is not really what people mean when discussing whether or not the “market” is overvalued.
You say Price Indexes, I say Price Indices
When the financial press and aficionados refer to the stock market and its relative value over time, they are typically referring to a particular stock price index, such as the Dow Jones Industrial Average (DIJA), the S&P500 index, the Nasdaq Index, or even the Russell 2000.
These stock price indices2 are not themselves exchanges. They are measures that summarize the overall value of a group of stocks, which may trade on the Nasdaq exchange or the New York Stock Exchange.
A stock price index is similar in spirit to other indexes this blog has discussed, the Consumer Price Index (CPI), or the Personal Consumption Expenditures Price Index (PCEPI). But, instead of tracking the prices of goods and services, a stock market price index tracks the prices of a number of different stocks—IBM, Meta, Nvidia, Southwest Airlines, and so on.
The S&P500 price index, for example, tracks the stock prices of the top 500 publicly traded companies in the United States. “Top” is measured by the total value of each company as determined by its stock price and the total number of shares of stock for that company available to the public. The latter is referred to as the “market capitalization” of the company or “market cap” for short. So,
Market Cap = Stock Price x Total Number of Shares
The total “market cap” of all 500 companies in the S&P500 price index is about $51 trillion. While there are thousands of publicly traded stocks, the value of the top 500 represents about 80 percent of the total value of all of those stocks.3
And just like the CPI is a “weighted” price index, so too is the S&P500 stock price index. What that means is that while the value of the price index—like 5900 or 6000— represents an average of all 500 stocks within the index, all stocks are not “created equal.”
For example, the top stock in the S&P500 price index is Apple, Inc.4 The current market cap of Apple, Inc. is about $3.8 trillion, making it the largest company in the United States (in terms of market cap). That implies that Apple’s market cap is about 7.5 percent of all companies in the index ($3.8 divided by $51 trillion).
In contrast, the smallest company in the index is Amentum Holdings, a company with a market cap of about $5 billion. The weight of that company in the index is only 0.1 percent.
The relative weights imply that a change in the price of Apple’s stock has a much bigger impact on the total value of the index than a change in the price of Amentum’s price. That means the larger companies, like Apple Inc., have a disproportionate influence on the overall increase or decrease in the S&P500 index. In fact, the ten largest companies in the S&P500 account for about 35 percent of the total market capitalization of the index.5
Buy? Sell?
To say the stock market is overvalued implies that the value of a stock price index is “too high.” The S&P500 is probably what most people have in mind since it represents most of the value of all stocks traded in the U.S. (as mentioned just above).6
Figure 1 displays the values of the S&P500 at the monthly frequency from January 1985 to December 2024 (the monthly observations represent the value of the index on the first day of each month, hence the last observation being for December 2024).7
The annotations on the figure point out dates which signified, at the time, historical “all-time highs.” After August 2000, the index did not reach another all-time high for another seven years. Yet, since October 2007, the S&P500 stock price index has achieved all-time highs on a regular basis—in spite of the many downturns and undulations along the way. I have identified a few of the highs—May 2015, September 2018, and a few others—but notice there are many other months I could have marked along the S&P500’s ascent from the early 2010s to this month.
In the case of any of the all-time highs identified on Figure 1, there were probably numerous prognosticators declaring the market was overvalued. What overvalued to most finance people means is that the stock prices of companies are higher than they should be, given how those businesses are actually doing, or anticipate doing in their industries (how much future revenue and profit they are likely to earn, for example).
“Overvalued” means the current prices of the stocks do not seem to make sense. As such, saying a stock or a price index like the S&P500 is overvalued implies it is a good time to sell ones stocks, to “get out” of the market, and wait for prices to come back down.
Hold!
The problem with getting out of the market, based on a belief that said market is overvalued, is how many times the so-called experts have been wrong in making such a claim. Figure 1 shows us a few of those times.
The truth is nobody knows if this month represents an “overvalued” stock market, just as no one really knew in any previous instance. Such prognosticators may have a lot of credentials and experience—and good for them—but for all their wiles, that does not give them any insight into what is going to happen next.
If one sells at an “all-time high,” you can certainly walk away feeling good about the money you made in stocks. But, how much future gains were forfeited if one sold at any of the previous all-time highs?
Ultimately, what any particular decision a stock owner makes is very personal. How close to retirement is that person? How much of their wealth is devoted to stocks? How secure is their employment and career path? What financial obligations do they have in the near and long term? And on and on.8 The decision should not be based on what somebody on cable TV or Instagram says, even they are a hedge fund billionaire, an “industry veteran,” or some other important sounding person.
In fact, if I hear someone saying stocks are overvalued, I figure that is probably a good time to stand pat.
In practice the company will hire an investment bank to handle the logistics and legal aspects of “going public.”
There are almost 12,000 publicly traded stocks in total. About 3500 are listed on the Nasdaq and about 2500 listed on the NYSE. The rest trade “over-the-counter.” See here for more detail.
The list of the top stocks in the index is from the “Factsheet” about the index available here. The information is as of November 29th of this year. As of that date the top ten stocks in the index in order are as follows: Apple Inc., Nvidia Corp, Microsoft Corp, Amazon.com Inc., Meta Platforms Inc (Class A), Alphabet Inc A, Tesla Inc, Berkshire Hathaway B, Alphabet Inc C, and Broadcom Inc.
The Dow Jones Industrial Average (DIJA) is also cited frequently, though offers a much narrower view of the “stock market,” since that price index only contains 30 stocks. One could also cite the Russell 2000 or Russell 3000, but those indices include very small companies whose stock price movements have very little effect on the overall market.
Values for the index represent the adjusted closing price for the index, meaning the price adjusted for stock splits, dividends and other corporate actions over time. See here for explanation.
All of those personal details are something that one would discuss with a financial planner. And, the timing of when to buy and sell stocks will be explicitly be tied to those personal details and the financial plan that is developed based on those details.
OK. But maybe we should look at price-dividend ratios or the CAPE index now.