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).