By Noah Solomon

Special to the Financial Independence Hub

The Buffett indicator is a simple ratio that compares the market capitalization of the U.S. stock market to its GDP. Buffett himself warns that if this ratio reaches 200%, “you are playing with fire.” At its current level of approximately 234%, this indicator is higher than it has ever been, including at the peak of the dot-com bubble in the early 2000s.

The cyclically adjusted price/earnings (CAPE) ratio is a well-known metric invented by economist and Nobel Laureate Robert Shiller. The S&P 500 Index’s CAPE ratio currently stands at 36.6, which is higher than 98% of monthly readings since 1881, and more than double its 140-year average.

To be fair, the current nosebleed levels of the Buffett indicator and the CAPE ratio can be partially explained by today’s record low interest rates. Furthermore, equity markets have become increasingly dominated by technology-driven and/or software-as-a-service (SaaS) companies with above average profitability. This shift may render current valuations less comparable to those of the distant past.

Regardless of the valuation metrics you use or whichever “this time it’s different” adjustments you make, stocks today range anywhere from somewhat expensive to obscenely overvalued.

Since 2008, financial markets have benefited from an unprecedented period of low-interest rates. When the pandemic began to ravage the globe in early 2020, the Fed cut interest rates to near zero and began pumping hundreds of billions of dollars into financial markets. By purchasing Treasury bonds and government-backed mortgages, the Fed has continued to inject approximately $120 billion into the economy each month.

Leaving interest rates at levels below inflation for an extended period is like putting a giant hose in the ground – water will come up somewhere. In the case of monetary stimulus, the “water” manifests itself in rising asset prices. According to legendary investor Marty Zweig:

In today’s markets, you don’t have to look very hard to find strong evidence of Zweig’s theory, which explains why stock markets were making fresh highs during successive outbreaks of Covid-19 and spiking unemployment. It also explains why approximately two thirds of stock returns over the past decade are attributable to multiple expansion rather than earnings growth.

Those who think that the huge gains in everything from stocks to art to cryptocurrencies to real estate over the past 12 years are solely the result of economic growth and corporate ingenuity should avoid anyone selling GameStop options! The market’s dependence on low rates cannot be overestimated. Interest rates giveth and taketh away. Should the central banks succeed (or over succeed) in getting the inflation genie out of its bottle, equities could be in for a nasty ride.

Extreme valuations are only one of the features that have historically accompanied asset bubbles and subsequent busts. Another harbinger of future misery has been accelerating gains. Prior to both the tech-wreck of the early 2000s and the global financial crisis of 2008, market returns had shifted from normal to worryingly unsustainable. Accelerating gains can be thought of as a rubber band that is being stretched further and further. The more you stretch the band, the greater the likelihood that it will snap.

As the following chart demonstrates, average equity market returns have been accelerating to the point where they are at their highest levels in five years.

Excessive speculation is another common ingredient in the recipe of historical bubbles. Whereas it’s never precisely clear what percentage of market activity is driven by short-term speculators (i.e., gamblers) as opposed to long-term investors, there are some clear signs that the lunatics are at least helping to manage (and possibly running) the asylum.

If you think information may surface that will cause people to recognize that a company is worth much more than its current value, then you would either purchase its shares or buy long-dated call options. By contrast, short-dated call options represent speculation in its purest form. Buyers of five-day options have no reasonable expectation that meaningful new information will emerge over that period – they are simply gambling. Continue Reading…