How to determine if a stock or the market is overvalued or overpriced? Of course, the P/E can be the simplest of measures. But there are other ways too. Let us look at 5 indicators of an overvalued stock market, without going too much into details of specific stocks. Here is how to tell if a stock expensive and if the market overall is expensive. None of these are exhaustive measures and should ideally be used in conjunction with other measures.
5 signs that the stock market is overpriced
There some very revealing quantitative and qualitative measures that you can use to determine if the stock price is overpriced or not. Here is a list of five such parameters.
Markets are close to bottoming out when P/E is close to historical lows and dividend yield are well below 1. It is hard to point exactly where the stock markets will top out but P/E ratio and dividend yields can give you a rough idea that markets are in problem territory. For example, Nifty P/E of above 27 has always indicated serious problems in valuations. More so if this is combined with dividend yields at below 0.75. This is normally the case of extreme over pricing and one must tweak their portfolio accordingly or hedge it.
Another classic give away of an overpriced market is when the prices are growing much faster than the growth in earnings. For example, if the earnings are up by 5% and the index as a whole has been re-rated by nearly 7X then there is a really valuation problem on hand. It only means that the stock markets are discounting earnings as long as 4-5 years into the future. That kind of optimism in the market is a classic case of overpricing in the market and one should act accordingly to either hedge or exit the stock positions altogether.
You must be very careful of overpricing when most retail investors are overly bullish on the market. There is a popular quip in Wall Street that when the office boy and the lift man start giving you tips on how to buy multi baggers then it is time to sell out. When markets overpriced, you will find a rapid spread in the equity cult and almost everyone seems to have positions in equities. That is a classic giveaway. In fact, this trend gets all the more confirmed if the FIIs are regularly selling. Track their actions on a weekly basis to get a clear trend.
GDP is likely to go into a much a lower plane. We saw this example in China wherein the GDP growth rate came down sharply from around 10% real growth to less than 6.5%. That also resulted in substantial erosion in the market cap. Normally, the market overall is highly sensitive to sharp fall in the GDP or the GDP growth getting into a lower plane. Try applying the reduced GDP and plot the Market Cap / GDP ratio and you will get the answers to your question.
Tightening of liquidity is a prime example of markets being overpriced. In a country like India where the floating stock is still limited and valuation is still liquidity can still make a substantial difference. For example, when the US Fed announced the tightening of liquidity in 2013 via a tapering of its liquidity infusion program or when the US Fed announced the first rate hike after 9 years in January 2016, the impact on the Indian market was to the tune of nearly 15%.
Apart from the above factors, one must also keep an eye on the rupee value in the Indian context. Normally, when the rupee starts depreciating in a secular fashion, it is a classic instance of the market being grossly underpriced. That is because, FII investors are likely to see their returns eroded in dollar terms and that may mean a rush to the exits. We have seen that happen so often in the past with the latest case being in 2018 itself. Just keep a watch for these parameter shifts.
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