Overvaluation of the Stock Market Essay

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Introduction

Stock markets are considered to be among the most preferred investment platforms by investors, as they generate a high return on investment (Fong, 2014). There are many underlying reasons for this high return, one of which may be the valuation of the financial commodities traded in the stock market (Chang, 2005). Some financial analysts believe that the stock markets are extremely overvalued (Phoenix, 2014), while there are others who consider them as being slightly overvalued (Rosenberg, 2010). Another school of thought has a viewpoint that they are fairly valued (Wolf, 2008); while, some hold the opinion that they are undervalued (Pan, 2009). Due to these differences in viewpoints, it becomes difficult to gauge the extent to which stock markets are overvalued. The reasons for these differences in opinions are the different geographical locations (Tan, Gan and Li, 2010) and the different assumptions made in comparisons (Cheng and Li, 2015). The difference in the methods used for valuation also turns out to be one of the reasons, as every method has its merits and demerits (Khan, 2002). Stock market overvaluation may have severe negative effects including a market crash or increasing organisation’s agency costs, which need to be considered by managers in organization-wide strategic management (Jensen, 2005).

Methods used for Stock Valuation

Various methods are used for stock valuation; some of the common ones include Price to Earnings ratio (Stowe et al., 2008), Knowledge Capital Earnings (Ujwary-Gil, 2014) and Dividend Discount Model (Adiya, 2010). The price to earnings ratio is the most common method used to evaluate stock markets, whereby the company’s current stock price is compared with the predicted earnings it will yield in future (Stowe et al., 2008). Knowledge Capital Earnings – KCE is another method through which a company’s intellectual capital can be gauged and interpretation of the extent to which it is overvalued can be given (Ujwary-Gil, 2014). The KCE method, however, is specifically subjective if the analyst is interested in estimating the potential future earnings of an organization (Ujwary-Gil, 2014).

The Dividend Discount Model is based on the assumption that the price of a stock at equilibrium will be equal to the sum of all its upcoming dividend yields discounted back to its current value (Ivanovski, Ivanovska and Narasanov, 2015). One of the shortcomings of this model is with the company’s growth estimation, in which the averaged historical rates do not provide an accurate picture, as they ignore the ongoing economic conditions and the changes that take place in the company (Ivanovski, Ivanovska and Narasanov, 2015). Another issue identified by Mishkin, Matthews and Giuliodori (2013) is related to the accuracy of dividends forecasted based on the company’s past performance and the predicted future trends of the market; critics cast doubts on the accuracy of these figures, as they are purely based on estimation of analysts and may not be always correct.

Stock Markets are Extremely Overvalued

Hussman (2014), who is well-known for his accurate insights about the financial markets, comments in one of his speeches that due to their Zero Interest Rate and Quantitative Easing policies, the central banks have driven the stock prices up to twice as high as they are supposed to be. This imparts the stock markets to be overvalued by 100%. While different authors argue that every evaluation metric has its merits and demerits, which makes it difficult to conclude whether stock markets are overvalued when calculated via a specific metric, a Phoenix (2014) report provides evidence of the fact that stock markets are overvalued by almost every metric used for valuation. According to Autore, Boulton and Alves (2015), short interest rates are also a determinant of stock valuation; the lower the short interest rate of the initial stock, the more overvalued the stock will be.

An example could be that of the U.S. stock market which is analysed to be overvalued by 55% (Lombardi, 2014), while it is estimated to be overvalued by 80% according to another research (Heyes, 2015). Lombardi (2014) identifies it to be overvalued to such an extent due to the increasing presence of bullish stock advisors as compared to bearish advisors, which results in the investors being complacent without being anxious about a huge market sell-off. By evaluating the market through various methods, Tenebrarum (2015) established an opinion that the U.S. stock market is valued at its highest peak to date. Additionally, Lombardi (2014) recognises these indicators to be similar to those before the stock market crash in 2007. Hence it may lead us to a prediction that history might repeat itself, as specialists have already expected the forthcoming crash (Heyes, 2015).

Reasons behind Extreme Overvaluation

Moenning (2014) explains one of the reasons behind stock overvaluation to be investors’ inclination to fall in the trap of investing based on stock valuation, instead of business cycles. He further elaborates that due to the investors’ inclination towards highly valued stocks, companies raise their stock prices to make their stock seem attractive to be preferred by investors over that of other companies. Qian (2014) identifies a solution to this that if investors are discouraged from merely considering stock valuation while looking for investment options, companies will not have an incentive to undertake systematic mispricing of their stocks, which results in overvaluation.

Another reason behind overvaluation of stock market has been suggested by Autore, Boulton and Alves (2015); according to whom the stocks are overvalued to a great extent due to the higher levels of failure to deliver. Three major exchanges report a huge number of failures to deliver in their daily listings approximately equal to 10,000 shares or 0.5% of the overall outstanding shares, which further explains the reason behind extreme overvaluation of stock markets (Autore, Boulton and Alves, 2015).

Stock Markets are Slightly Overvalued

Some analysts estimate the stock markets to be slightly overvalued as compared to what their value should be. Rosenberg (2010) further strengthens this point in his research which revealed that stock markets are overvalued by 35%. A Newstex (2010) report provides little evidence about the market being overvalued by 26%. Specialists from this school of thought believe that stock overvaluation may only result in a temporary disruption in the market, which may be resolved by cautiously reducing the stock prices.

Stock Markets are Fairly Valued

The ideal situation is the one when stock markets are appropriately valued, which Wolf (2008) identifies as an opportunity. He says that fairly priced stock markets are favoured by the investors and risk-seeking governments, as it is the situation with lesser uncertainty. With an overall market yield of 4%, Paler (2012) recognised the stock markets to be fairly valued, regarding them as a suitable investment platform. For example, Newstex (2015) reported Amazon’s stock price to be fairly valued at $295 per share as opposed to $380. This is because financial analysts believe that factors such as the potential decline in the annual revenue growth, reduction in operating profit margins due to increasing technology, marketing and other costs, and increased investment in growth strategies, such as international expansion, need to be accounted for when valuing stocks. It can thus be understood that overvalued stocks pose to be a threat for the financial markets because investors lose confidence, which results in a drop in revenue growth (Akbulut, 2013). The slightly overvalued stock markets may find their easy escape if the decline in the Central Bank rates results in a decrease in the wider interest rate spectrum (Saler, 1998).

Stock Markets are undervalued

Pan (2009) supports the claim that stock markets are undervalued, along with which he gives the example of the Asian stock market, which is approximately 30% undervalued. One of the reasons he identified for it was the political instability. Another example is provided by Pawsey (2009), whereby he analysed that most of the UK stock market remains undervalued and it has not been so in decades. The reason he identified was that the stocks are undersold as compared to the sales estimation. On one hand, the U.S. stock market is viewed as being extremely overvalued, while on the other, the U.K. stock market is severely undervalued. It can thus be seen that the geographical location plays a great role in the differences of opinion about overvaluation and undervaluation of the stock markets (Tan, Gan and Li, 2010).

There are some specific markets which are consistently undervalued for certain periods of time. An example could be the Russian stock market; Putin (2008) found Russian companies to be severely undervalued. Caldwell’s (2015) analysis also depicted that Russian stock market is among the three most undervalued markets globally. The analysis also included predictions that the Russian stocks might go down further, therefore investors need to beware before investing in such markets.

Reasons behind Stock Undervaluation

One of the reasons behind undervaluation of stock markets is the investor’s inclination towards highly valued stocks. Although some companies set their stocks at a lower price to make them seem cheaper and more attractive for the investors to buy, they find the investors doing the opposite, i.e. opting for highly valued stocks in anticipation of higher returns (Warner, 2010).

Reasons for Different Viewpoints
Different Assumptions and Valuation Methodology

The different viewpoints mentioned about stock valuation are based on the different assumptions (Cheng and Li, 2015) and different methods used for valuation (Khan, 2002). It also follows that these different methods have their own advantages and disadvantages, which if accounted for, may result in a different perspective. For example, price to earnings ratio is considered to be a worthless tool by some analysts because of its overoptimistic estimates (Tenebrarum, 2015). Taboga (2011) identifies another issue with this ratio, that it is mostly influenced by the fluctuations in earnings due to the business cycle oscillations. Hence he assumes that relying merely on this method may not provide a true picture of the extent to which stock market is overvalued.

Implications of Overvaluation

Hunter, Kaufman and Pomerleano (2005) explain that extreme overvaluation of the stock market should be taken into consideration and a solution should be devised for it, otherwise there would be higher probability of a crash. Liao (2014) also found a positive relationship between highly overvalued markets and possibility of a crash. He also found a negative relationship between extreme overvaluation and future share price jumps. Jensen’s (2005) study revealed that the overvaluation of a company’s stock gives rise to certain organisational forces which become difficult for the management to handle, damaging the organisation’s core value either partially or entirely.

On one hand, overvalued stock markets pose threats to the financial markets, while on the other, they help in boosting up the aggregate demand and supply, such that this positive effect may potentially be able to subside the negative effect (Cecchetti et al., 2000). Jones and Netter (2012) believe that mispriced stocks prove to be a source of encouragement for investors to trade, as a result of which they are reverted back to their reasonable prices.

Conclusion

The valuation of stock markets has long been an area of concern for financial institutions and analysts. The differences in valuation and the opinions regarding valuation occur because of the differences in the methods used for calculations and making estimates. Each method has its pros and cons and research suggests that one method alone cannot provide a true picture of the degree to which stock markets are overvalued or undervalued. There is evidence about stock markets being extremely overvalued, and there is also an equal amount of research suggesting they are fairly valued and/or undervalued. Considering the differences in methods used and the variation in geographical locations where these researches are conducted, it is difficult to hold a strong opinion about the extent to which stock markets are overvalued or undervalued, because critics against each school of thought have logical reasoning proving the limitations of the valuation method used by the other analysts. It is therefore necessary for the analysts to use a combination of two or methods for stock valuation, so that the doubts of the critics may be reduced, ensuring transparency in the financial data analysis.

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