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The valuation of the S&P 500 (SNPINDEX: ^GSPC) has been a hot topic lately. By some measures, the index looks historically pricey, trading at levels rarely seen before. At the same time, the S&P 500 is trading at a historically low PEG (price/earnings-to- growth) ratio.
Let's take a close look at whether the market is overvalued or undervalued.
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Based on two popular market valuation metrics -- the Buffett indicator and the S&P 500 Shiller CAPE (Cyclically Adjusted P/E) ratio -- the market is trading near record valuations. You often see these metrics cited as a reason for a potential bear market.
The Buffett indicator is named after famed investor Warren Buffett because it has long been one of his favorite stock market valuation metrics. It takes the total market cap of the entire U.S. stock market and divides it by gross domestic product (GDP). The ratio is meant to be a simple gauge that tells investors whether the market is trading at a reasonable valuation relative to economic output, or whether expectations are running too high.
Stocks are considered reasonably valued in a 75% to 90% range, and overvalued when they trade at over 120%. The Buffett indicator hit 172% during the dot-com bubble, and it currently sits at over 235%, its highest level on record.
In a 2001 Fortune article, Buffett called the metric "probably the best single measure of where valuations stand at any given moment." However, the Oracle of Omaha's recent actions show he may have changed his mind. After a long stretch of net equity selling (3.5 years), Buffett's Berkshire Hathaway returned to being a net buyer of stocks last quarter. The conglomerate also returned to repurchasing its own stock after a long hiatus.
The CAPE ratio is also flashing red, sitting above 40x. The only other time the metric hit this level was during the dot-com boom, right before the bubble burst. The metric divides the S&P 500's current price by its inflation-adjusted earnings over the past decade. The purpose of this is to smooth out profits caused by business cycles and help predict future returns over the following decade.
Arguably, the biggest flaw of this metric is that the makeup of the S&P 500 index is much different today than in the past. Unlike 10 and 20 years ago, when industrial, financial, pharmaceutical, and energy stocks were among the market leaders, today the index is dominated by less cyclical mega-cap tech companies with more stable and visible earnings and stronger growth. Because of that, they also tend to carry higher earnings multiples. The CAPE is also capturing older S&P 500 earnings, when the makeup was more cyclical.
While the Buffett indicator and CAPE ratio suggest the market may be overvalued, the S&P 500 PEG ratio is at its lowest level in at least 30 years. The S&P 500 PEG currently sits around 0.7x, according to Yardeni Research, which uses a five-year forward consensus annual earnings growth rate.
PEGs under 1 are typically considered undervalued, and the S&P 500 average over time is around 1.3 times, according to Yardeni. Meanwhile, the index's PEG ratio has only sunk below 1 on just four other occasions since 1995.
The biggest knock on this metric is that it is dependent on future growth estimates. If that growth doesn't come to fruition, the metric becomes pretty useless.
If you're familiar with the basics of quantum computing or just a fan of the TV show The Big Bang Theory, you may have heard of the thought experiment commonly called Schrödinger's cat. This is a thought experiment that illustrates the bizarre concept of quantum superposition by placing a hypothetical cat in a sealed box with a lethal trigger. The theory states that particles exist in multiple states until measured. Until the lethality is triggered, the cat could be alive. But opening the box to observe the cat alive triggers the lethality. So until the box is opened to observe whether it is alive, the cat can be considered both dead and alive.
Until we see how the next five years of market growth, led by AI infrastructure spending, play out, the market can be considered both overvalued and undervalued. As such, I wouldn't change any investment strategy and would recommend using a core index exchange-traded fund (ETF), like the Vanguard S&P 500 ETF (NYSEMKT: VOO), or the Invesco QQQ Trust (NASDAQ: QQQ), which tracks the Nasdaq-100 index, to dollar-cost average into. This will help build wealth over time, regardless of whether stocks are overvalued or undervalued.
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Geoffrey Seiler has positions in Invesco QQQ Trust and Vanguard S&P 500 ETF. The Motley Fool has positions in and recommends Berkshire Hathaway and Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.
Is the S&P 500 Historically Expensive or Cheap? The Answer Depends on How You Look at It. was originally published by The Motley Fool
