2020 Is The Most Overvalued Equity Market In Our Lifetime
Updated: Jul 24, 2020
At the end of Q2, the market valuation of domestic companies relative to nominal GDP exceeded the tech bubble peak of Q1 2000. In other words, "2020 Is the Most Overvalued Equity Market in Our Lifetime".
Domestic Market Capitalization
According to my estimate, the ratio of market capitalization of domestic companies to nominal GDP stood at 1.93 at the end of Q2 2020, above the previous record high of 1.87 in Q1 2000, the peak of the tech bubble. The Q2 estimate is based on a market valuation of domestic companies of $38.7 trillion, up 20%-plus from Q1, and a 7% (not annualized) decline to $20 trillion for Q2 nominal GDP.
The actual figures will not be known until the Federal Reserve issues the Q2 Financial Accounts report in early September and the Bureau of Economic Analysis issues its estimates on Q2 GDP. But the market valuation of domestic companies is already a known fact based on the gains in equity prices. And consensus estimates of Q2 GDP show a sharper drop than 7%, so it's almost a given that the ratio will hit on a record high in Q2.
History shows that investing in relatively high macro valuations is a bad strategy. For example, for investors that entered the equity market during the peak of the tech bubble in Q1 2000 and remained invested until the equity market reached a new peak in 2007 the annual rate of return for the S&P 500 was less than 1%.
History often repeats itself in the world of finance. The happy prophecy of a strong rebound in growth and endless gains in corporate earnings nowadays is reminiscent of the tech bubble. Just like in 2000 equity investors are focused on momentum, ignoring record valuations.
The old saying "this time is different" is being used again. And it is different because the Federal Reserve had flooded the system with excess liquidity. But the fundamental "rules of investing" have not changed, only suspended by the unprecedented actions of policymakers. Macro measures of equity market valuations offer investors a fundamental assessment of the risk-reward ratio of investing at various points in the business cycle. Current record market valuations indicate an extremely poor risk-reward ratio, even worse than what followed the tech bubble of 2000.