“All the Whos down in Whoville liked Christmas a lot. 

But the Grinch, who lived just north of Whoville, did not!”

– Dr. Seuss

The annual holiday classic, that we’ve all seen a million times, tells the story of a nasty green cave dweller who tries to stop Christmas. 

Despite the fact he eventually learns the true meaning of Christmas and saves the day, his name has become synonymous with being cynical or mean-spirited.

Well, since the holiday season is at hand, we want to say up front that we really don’t mean to be a Grinch about the markets.

But given we feel it’s our duty to show our readers the unvarnished investing truth, here’s a development you need to know…

Recalling the “Value Master”

A couple weeks back, we took note of the fact that none other than Warren Buffett — mister buy and die — had become a net seller in the stock market.

Buffett, who still actively manages Berkshires’ portfolio, has been a net seller of stocks for the past eight quarters, significantly rearranging his portfolio. …

Add it all up and Buffett has raised Berkshire’s cash position to $320 billion versus just $272 billion in stocks.

We speculated on the reasons for this notable shift in sentiment:

Is the Oracle calling a top? It’s certainly not impossible. Buffett is the king of buying value — great companies fairly priced. If valuations are exceeding what he deems reasonable, he may be building a cash store to take advantage of a major correction.

We also noted that Buffett is not a market timer. So the fact that he’s unloading now doesn’t suggest that anything is imminent.  Better to be out when you want to be in instead of in when you want to be out.

But given our speculation, we found a recent analysis of the market’s overall valuation to be worth noting. But first…

A Little Primer On Valuation

When you buy a stock, you’re basically buying a piece of the company’s expected future earnings. And the price you pay today should reflect a discounted value of that. So in basic terms, price should be a fair reflection of value. But that’s not always the case.

Comparing the price of a company’s stock to its earnings (price-earnings or P/E ratio) is the most common way of establishing valuation. Below is an historical chart of the P/E ratio of the S&P 500:

You can see that for over 100 years, valuations basically oscillated around the long-term mean with a dip 50% below indicating undervalued and rise to 50% above indicating overvalued. Then, however, came the tech bubble and valuations became both extreme and extremely volatile.

Another, more smoothed measure, is known as the cyclically-adjusted price-earnings (CAPE) ratio. (It’s also known as the Shiller PE Ratio for the economist Robert Shiller who invented it.) This ratio measures price to earnings except instead of using a single year of earnings, it uses average real earnings over a 10-year period. This smooths out volatility as a result of business cycles. 

You can see this measure smoothed things out considerably leaving only two overvaluation spikes: before the crash of 1929 and the bust that followed the tech bubble… until today.

Today valuations according to the Shiller ratio are at their second highest levels in history. 

But there’s yet one more level of smoothing that can be done…

It comes from Damien Cleusix of QuantasticWorld and it’s called the margin-adjusted, cyclically-adjusted price-earning ratio (MAPE). 

MAPE factors in and adjusts for the level of profit margins embedded in the valuation calculation.  
And by this measure the market isn’t just overvalued… It’s insanely overvalued.  According to Cleusix “the US stock market is the most overvalued it has ever been.”

Looking at this chart, the sky-high valuations (the level traced in green) are obvious.  Further, if you construct a band with boundaries between the 0 and 50 percentiles of historical MAPE, this is what you get:

According to Cleusix:

The S&P 500 is currently almost 400% above the level corresponding to a bottom MAPE and 130% above the 50% percentile MAPE history.

Valuations at the high end of any measure suggest that an investment is “priced for perfection” — that earnings and growth will continue ad infinitum. And that leaves the door open for any kind of disappointment to send prices plummeting back to more “reasonable” valuations.

Like we said, we don’t want to be Grinchy this close to the holidays. But being aware of the potential threats to the market (and the bad news that could result) is the key to actually having a merrier Christmas!