MSG Team's other articles

10052 Issues in Determining Discount Rate for Valuation of Sports Franchises

In the previous article, we have already understood the method used for deriving the discount rate which is used while deriving the valuation of sports franchises. The method was described in detail. However, even though theoretically, there is a method available to derive the discount rate, there are several practical issues that make it difficult […]

11785 The Voting Process

After the solicitation, packages are sent out, and the creditors are given all the information that they need, it is time to vote. Voting is an important part of the reorganization process. This is the part where the will of the creditors becomes known to the debtor organization and to the public in general. However, […]

11887 What is Prototyping?

In the previous articles, we have already studied about the proof of concept as well as the minimum viable product concept. However, there is one more methodology that is commonly used in the product development stage after the seed funding has been received. This mechanism is known as “prototyping”. In this article, we will further […]

11810 What are Bonds? – Characteristics and Different Types of Bonds

Why Investment is Important ? Every individual needs to put some part of his income into something which would benefit him in the long run. Investment is essential as unavoidable circumstances can arise anytime and anywhere. One needs to invest money into something which would guarantee maximum returns with minimum risks in future. Money saved […]

12282 Advantages of Public Private Partnership Model

Building stadiums or other sporting venues is an essential activity that plays a crucial role in the success or failure of sporting leagues as well as sporting franchises. However, as we have seen in the past articles, the financing of such stadiums is not an easy task and requires committing huge amount of money as […]

Search with tags

  • No tags available.

All stock market investors know that markets go through periods of euphoria and panic. During periods of euphoria, investors keep on buying shares in the hope of a higher payoff. In technical terms, this is the situation wherein the entire market becomes overvalued. The opposite of this also happens when fear grips the market, everybody starts selling all their shares and the market becomes undervalued.

The problem is that overvalued and undervalued markets are normally seen in hindsight. Most investors believe that the market that they are in at the present moment is fairly valued. If the market is overvalued, experts often come up with theories that suggest why this time it is different and why overvalued markets are going to be the new norm. Hence, if an investor is genuinely able to ascertain whether or not a particular market is overvalued, they have a definite edge over the others in the marketplace.

In this article, we will have a closer look at some of the factors that help investors identify overvalued markets.

How to Identify an Overvalued Market?

An overvalued market can be identified by making comparisons with the right frame of reference.

  • One of the best ways of identifying an overvalued market is by looking at the price to earnings ratio of the market as a whole. This ratio is calculated the same way as it is calculated for one individual stock. In fact, this number is easily available in the marketplace as several analysts do use to evaluate the economy.

    A weighted average of the price earnings ratio of the companies that make up the index is used to calculate the price-earnings index of the entire market.

    Generally, the price-earnings index stays around the mean. This means that if you calculate the price earnings ratio based on historical data, the average is the normal Price Earnings ratio.

    Hence, if the present P/E is much greater than the historical average, then the market is overvalued. This is exactly what happened in the case of the Great Depression, the dot com bubble as well as the Great Recession of 2008.

  • The second and probably the most powerful indicator of identifying an overvalued market is by using the total market capitalization to GDP ratio. Under normal circumstances, the market capitalization is almost equal to the GDP.

    If this ratio falls below 0.7 or so, it could mean that the market is undervalued and could provide a buying opportunity.

    On the other hand, if this ratio crosses above 1.25, the market is said to be overvalued.

    The problem is that the numbers required to calculate this ratio are not available to the general public. However, there is a workaround. Neutral organizations like the World Bank keep on publishing this data every quarter. This number does not really change too much every day. Hence, a quarterly frequency is good enough.

Interpreting Undervaluation and Overvaluation

  • It needs to be understood that there is no uniform way to interpret the valuation differences in markets. For instance, it is possible for an entire market to be overvalued while at the same time one particular sector or a few stocks may be undervalued. Hence, one needs to be careful about the inferences that are made based on this data.
  • Also, if the market is overvalued does not mean that it will go down immediately. Hence, one should be careful not to go short on a market just because some ratios suggest that it is overvalued. It is a known fact that overvalued markets do return to the mean over the long term. However, in the short term, it is very much likely that the valuation may increase even further. There is a famous saying that the markets can remain irrational longer than you can remain solvent. It is best to make your bets with the money you do have. Also, it is important to avoid imposing any time frame on your actions.
  • Lastly, there are some markets which will appear to be chronically undervalued based on the above parameters. However, their valuation may be lower because of certain other factors. For instance, some countries constantly face political and military uncertainty. This is the reason why investors are not confident about making investments in such countries. When you look at the GDP to market cap ratio of such countries, they may appear to be chronically undervalued. However, it is likely that this situation will remain the same over the next few years. This is because the undervaluation is the result of political turmoil which is obviously not being covered by the metric.

To sum it up, the two metrics mentioned above do provide a mechanism to identify overvalued and undervalued markets. However, it needs to be understood that the recommendations cannot really be blindly followed. This is because there may be other factors involved too. Hence a thorough understanding of such factors is necessary before making any investment decisions.

Article Written by

MSG Team

An insightful writer passionate about sharing expertise, trends, and tips, dedicated to inspiring and informing readers through engaging and thoughtful content.

Leave a reply

Your email address will not be published. Required fields are marked *

Related Articles

Currency Wars: “Beggar Thy Neighbor” Policy

MSG Team

Cryptocurrencies and Taxation

MSG Team

Common Terminologies Used in Forex Markets

MSG Team