How to Identify an Overvalued Market?

All stock market investors know that markets go through periods of euphoria and panic. During periods of euphoria, investors keep on buying shares in the hope of a higher payoff. In technical terms, this is the situation wherein the entire market becomes overvalued. The opposite of this also happens when fear grips the market, everybody starts selling all their shares and the market becomes undervalued.

The problem is that overvalued and undervalued markets are normally seen in hindsight. Most investors believe that the market that they are in at the present moment is fairly valued. If the market is overvalued, experts often come up with theories that suggest why this time it is different and why overvalued markets are going to be the new norm. Hence, if an investor is genuinely able to ascertain whether or not a particular market is overvalued, they have a definite edge over the others in the marketplace.

In this article, we will have a closer look at some of the factors that help investors identify overvalued markets.

How to Identify an Overvalued Market?

An overvalued market can be identified by making comparisons with the right frame of reference.

  • One of the best ways of identifying an overvalued market is by looking at the price to earnings ratio of the market as a whole. This ratio is calculated the same way as it is calculated for one individual stock. In fact, this number is easily available in the marketplace as several analysts do use to evaluate the economy.

    A weighted average of the price earnings ratio of the companies that make up the index is used to calculate the price-earnings index of the entire market.

    Generally, the price-earnings index stays around the mean. This means that if you calculate the price earnings ratio based on historical data, the average is the normal Price Earnings ratio.

    Hence, if the present P/E is much greater than the historical average, then the market is overvalued. This is exactly what happened in the case of the Great Depression, the dot com bubble as well as the Great Recession of 2008.

  • The second and probably the most powerful indicator of identifying an overvalued market is by using the total market capitalization to GDP ratio. Under normal circumstances, the market capitalization is almost equal to the GDP.

    If this ratio falls below 0.7 or so, it could mean that the market is undervalued and could provide a buying opportunity.

    On the other hand, if this ratio crosses above 1.25, the market is said to be overvalued.

    The problem is that the numbers required to calculate this ratio are not available to the general public. However, there is a workaround. Neutral organizations like the World Bank keep on publishing this data every quarter. This number does not really change too much every day. Hence, a quarterly frequency is good enough.

Interpreting Undervaluation and Overvaluation

  • It needs to be understood that there is no uniform way to interpret the valuation differences in markets. For instance, it is possible for an entire market to be overvalued while at the same time one particular sector or a few stocks may be undervalued. Hence, one needs to be careful about the inferences that are made based on this data.
  • Also, if the market is overvalued does not mean that it will go down immediately. Hence, one should be careful not to go short on a market just because some ratios suggest that it is overvalued. It is a known fact that overvalued markets do return to the mean over the long term. However, in the short term, it is very much likely that the valuation may increase even further. There is a famous saying that the markets can remain irrational longer than you can remain solvent. It is best to make your bets with the money you do have. Also, it is important to avoid imposing any time frame on your actions.
  • Lastly, there are some markets which will appear to be chronically undervalued based on the above parameters. However, their valuation may be lower because of certain other factors. For instance, some countries constantly face political and military uncertainty. This is the reason why investors are not confident about making investments in such countries. When you look at the GDP to market cap ratio of such countries, they may appear to be chronically undervalued. However, it is likely that this situation will remain the same over the next few years. This is because the undervaluation is the result of political turmoil which is obviously not being covered by the metric.

To sum it up, the two metrics mentioned above do provide a mechanism to identify overvalued and undervalued markets. However, it needs to be understood that the recommendations cannot really be blindly followed. This is because there may be other factors involved too. Hence a thorough understanding of such factors is necessary before making any investment decisions.

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