Stocks Overvalued?

Mike Kauffelt, Chief Investment Officer

Answering the question above is difficult at any point in time, but particularly when so much data is at extremes. Interest rates are at 50 year lows. Total debt as a percent of our economy is at an all time high. Technology shares are coming out of a bear market of epic proportions and regular stocks are recovering from a bear market of significant proportions. The reason this makes valuing stocks so difficult is that we typically need to compare stocks against something. That valuation comparison is usually against their own past history or some alternative investment such as bonds. These relative valuation methods can work quite well when most of the data is near its historical average, but it does not give good indications at the extremes. It makes common sense that when you know a statistic is at an extreme, you will probably place less confidence in that indicator regardless of its direction.

Therefore, I’ve been looking for any indicators that are not necessarily valuation based, that might help us understand where stocks are from a historical perspective. I believe I found one. This particular indicator measures “stocks as a percentage of household financial assets adjusted for pension funds.” This measure and all the other data for this update was compiled by Ned Davis Research. The measure looks at the percentage of stock (includes equity mutual funds) owned by households, minus the stock they may own, but may not directly control, that is held in pension funds on the individuals’ behalf. This measure, as you might expect, shows households holding a lot of stock as a percentage of their wealth in bull markets and less in bear markets.

So where is this measure now? Well, it is about even with its fifty-year average. Over the past 50 years, households have held on average about 25.7% of their financial assets in stocks. Today, they are holding 29% in stock (through the first quarter of 2003). This is a dramatic decline from the peak of 49% in early 2000. This indicator may not tell us if the stock markets are fairly valued, but it does seem to say we are holding about the right percentage of stocks as we have held historically. The markets may fall or rise from here (we believe that stocks are headed higher) but at least it is more likely their direction will be based on the economy and earnings and not based on a supply / demand imbalance from being under or over owned by households.