Is the stock market overvalued in December 2020?

I have always wondered why investors ask this question but having worked for Old Mutual Assest Managers managing big client portfolios, I now understand why this question gets thrown around. For a long term investor this question is not as important as it is to the fund manager whose perfomance is measured on a quarterly basis. Let me explain:

Personally, I have a direct debit that buys shares on a regular basis ie mothly. By using this method one applies the dollar cost averaging technique mentioned in the book by Benjamin Graham; The Intelligent Investor. (To those that do not know this writer he was Warren Buffet's mentor). Dollar-cost averaging means investing a fixed dollar amount in the same investment at fixed intervals over time. Basically, this allows you to buy more shares when the stock market is undervalued and prices are low and fewer while it is overvalued and prices are high.

That being said, as an investor, one should know when the market is overbought or oversold just so they can excercise restraint and caution when it is needed. Investors who make money are contrarians who exercise greed when everyone is in fear and who are cautious when everyone becomes greedy. When the stock market goes up people flock to buy at the current all time highs and they panic when the stock market starts plummeting. Hence they are always buying high and selling low. By being contrarian you buy when the market becomes cheap (oversold) and sell when it becomes expensive (overbought). Although personally I never sell my stocks but I stop buying when the market is overvalued.

How do you know that the market is undervalued or overvalued?

Yale professor Robert Shiller, the author of Irrational Exuberance, came up with the following Price/Earnings (P/E) ranges to give an indication of how cheap or expensive stocks are:

0-7 Stocks are extremely undervalued

7-13 Stocks are undervalued

13-15 Fair value

15-20 Stocks are overvalued

20-25 Stocks are in a bubble

25-?? Stocks are in an extreme bubble

As you can see in the diagram above since the late 1800s the market has corrected as they reached or just passed the 20 PE mark and it has come down sharply once it gets to 40. This just goes to show that a wise investor would exercise caution when buying as you get less value in an overbought market. Personally in a stock market bubble I would invest in fixed income securities and wait for a correction. What is recommended is buying at fixed intervals which means when the stocks are expensive you buy less with the same amount.

At the moment the UK stock market has a PE of 20.420 and the S&P 500 all-share has a PE of 37.17. Suprisingly the FTSE still has not gone back to previous levels that it was before the pandemic and the S&P has just passed the 30k mark. As a buy-and-hold investor im not too worried of the 37 levels but will put the brakes on aggressive stock purchases for now.