Despite the complex situation in the Middle East, the main stock indexes in America remain at levels close to all-time highs. Although most analysts predict that a recession is imminent, investors, or rather speculators, seem to ignore it. Higher inflation readings should force central bankers to raise interest rates, triggering a global recession. But let me show you the top signs that the stock market is overvalued and at risk of crashing.

The Buffett Index

The first and most vital way to assess stock market overvaluation is the Buffett Index. As the name suggests, this measure was proposed by investing legend Warren Buffett as a way to measure the value of the US stock market in relation to the size of the country’s economy, namely its GDP. This can be calculated by dividing the total stock market capitalization by the value of US GDP.

A reasonable value for the Buffett Ratio should historically be around 100% or less. An amount between 70 and 80% is generally considered a reasonable investment opportunity. At the same time, a value close to or higher than 200% suggests a significant overvaluation and therefore high risk.

Right now, Buffett’s indicator is clearly flashing red.

Currently, the rate exceeds 220%, which is a critical level in history preceding a stern economic downturn. Even in the times of the Internet bubble, when there was a real frenzy on high-tech stock exchanges, the indicator was around 150%, which is lower than today. This suggests a high risk. But this is not the only signal of revaluation.

Shiller PE ratio

Another useful indicator is the Shiller PE ratio. It compares the average share price of the S&P 500 Index to 10-year average inflation-adjusted earnings. It is calculated using the following formula:

The diagram below shows the history of the Schiller coefficient over 100 years.

Source: lynalden.com

Currently, the ratio is close to 40, which was the value observed during the Internet mania in the early 2000s. The current Schiller Index is even much higher than it was during the Roaring Twenties, when there was an irrational stock market frenzy before the Great Depression. The current situation clearly indicates an overvaluation of the stock exchange.

Record household exposure to shares

Household stock exposure is calculated by dividing the market value of the stock by the net worth of U.S. households. This indicator measures lay interest in stocks, which is currently at an all-time high. The diagram below shows that this indicator even beats the era of the eminent Internet bubble.

Source: Bloomberg

The fact that household allocation to stocks is near all-time highs suggests that we are near the end of the bull market. This reminds me of the anecdote about the boy shining his shoes. When Joseph Kennedy, John Kennedy’s father, was walking down the street in 1929, he decided to have his shoes cleaned by a shoe shiner. The bootblack started giving him tips on how to choose stocks. Joseph Kennedy went to the stock exchange to get rid of his shares. This took place just before the dramatic decline in the US stock market just before the Great Depression. The message behind this anecdote is straightforward: investing in an asset class that is overly popular among investors without special experience is highly threatening. I think something similar is happening now. This brings us to the next problem: speculators buying extremely costly shares of companies with faint fundamentals.

Noise

The most obvious example we see today is artificial intelligence companies, which are often invested in for their future growth potential, or better said, buzz. Many expect some of these companies to generate excellent profits in the future. However, some of these companies are not currently profitable. Still, investors are willing to pay for their possible future now. Thus, the valuations of these companies reach record levels. This is, last but not least, a sign that the asset market bubble is about to burst, but the key question remains “when?”