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There are only two other times in history when stocks were more expensive than today

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We are having a hard time finding high-quality companies at attractive valuations.

For us, this is not an academic frustration. We are constantly looking for new stocks by running stock screens, endlessly reading (blogs, research, magazines, newspapers), looking at holdings of investors we respect, talking to our large network of professional investors, attending conferences, scouring for ideas published on value-investor networks, and finally, looking with frustration at our large (and growing) watch list of companies we’d like to buy at a significant margin of safety. The median stock on our watch list has to decline by about 35%-40% to be an attractive buy.

But maybe we’re too subjective. Instead of just asking you to take our word for it, we’ll show you a few charts that not only demonstrate our point, but also show the magnitude of the stock market’s overvaluation and, more importantly, put it into historical context.

Each chart examines stock market valuation from a slightly differently perspective, but each arrives at the same conclusion: The average stock is overvalued somewhere between tremendously and enormously. If you don’t know whether “enormously” is greater than “tremendously” or vice versa, don’t worry, we don’t know either. But this is our point exactly: When an asset class is significantly overvalued and continues to get overvalued, quantifying its overvaluation brings little value.

Great Depression, dot-com bubble

Let’s demonstrate this point by looking at a few charts.

The first chart shows price-to-earnings of the S&P 500 SPX, +0.45% [4]  in relation to its historical average. The average stock today is trading at 73% above its historical average valuation. There are only two other times in history that stocks were more expensive than they are today: just before the Great Depression hit and in the 1999 run-up to the dot-com bubble’s bursting.

We know what happened in both cases: Stocks declined — a lot. Based on over a century of history, we are fairly sure that, this time too, stock valuations will at some point revert to their mean and stock markets will decline. After all, price-to-earnings behaves like a pendulum that swings around the mean, and today that pendulum has swung far above the mean.

What we don’t know is how this journey will look in the interim. Before the inevitable decline, will price-to-earnings revisit the pre-Great Depression level of 95% above average, or will it maybe say hello to the pre-dot-com crash level of 164% above average? Or will another injection of QE steroids from central banks send stocks valuations to new, never-before-seen highs? Nobody knows.

One chart is not enough. Let’s take a look at another one, called the Buffett Indicator. Apparently, Warren Buffett likes to use it to take the temperature of market valuations. Think of this chart as a price-to-sales ratio for the whole economy, that is, the market value of all equities divided by gross domestic product (GDP). The higher the price-to-sales ratio, the more expensive stocks are.