We’ve written before about how, according to some fundamental metrics like the Buffett Indicator, stocks are currently overvalued.
With stocks continuing to hit record highs, that remains the case. And it seems unlikely to change anytime soon. After all, trends tend to last longer than investors expect, and the most bullish thing stocks can do is hit new highs.
Plus, the AI trend remains in full swing, and we’re in the midst of a Fed rate-cutting cycle, which is typically bullish.
At the same time, the S&P 500 returned more than 20% in 2023 and 2024 and could very well do it again this year. As I write this, the S&P 500 is up 17.5% year to date, and we’ve still got two months left in 2025.
Three years of 20%-plus gains isn’t unheard of, but it’s close. The last time it happened was during a four-year run from 1995-1998, before the dotcom bubble popped. It should be noted, however, that 1999 still saw the S&P generate double-digit gains (19.5%) before the bottom fell out.
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So this isn’t a warning to duck and cover or pile into gold, cash, and canned food. The best course of action is to stick to your long-term plans and enjoy these once-in-a-generation returns.
And, for the contrarians out there, it’s good to remember this warning from Keynes: “Markets can remain irrational longer than you can remain solvent.”
While betting against this market is a fool’s errand, that doesn’t mean we can’t be on the lookout for warning signs that stocks have become too overheated or that smart money is heading for the exits.
To that end, we’d like to share two charts with you. Consider the first chart a measure of risk in the market and the second a measure of when to start taking that risk more seriously (in other words, when the top is in).
2 Charts to Help You Trade Smarter While Stocks Are Overvalued
The first is this chart of total margin debt as a percentage of M2 money supply.
Margin Debt as a Percentage of Money Supply
This chart is derived from total margin debt as reported by FINRA and the M2 money supply, as reported by the St. Louis Fed.
We’ve previously written about M2 money supply as a measure of total liquidity in the market (and the raison d’être for the persistent bull market itself), so measuring margin debt against money supply is an attempt to divine exactly how much extra “juice” leveraged borrowing is providing.
That chart begins in 1999 and runs through August of this year (the last full month of M2 data).
With margin debt rising from $1.06 trillion in August to $1.13 trillion in September, it has almost certainly eclipsed 5% for the first time since immediately prior to the Great Recession (and prior to the dotcom bubble before that).
There’s no specific threshold at which this becomes a sell signal. After all, the dotcom era saw this figure rise above 6%.
It is, however, a warning against complacency, as margin borrowing exacerbates the effects of bad news, especially should forced selling come into play.
The second chart, which is more of a timing signal, is a five-year (weekly) chart of the S&P 500.
S&P 500 - RSI & OBV
The most important era of that chart, at least for our purposes, is the end of 2021, which also marked the end of the last bull market.
As you can see, the RSI (top section) was periodically overvalued (above 70). We’re seeing that a bit now as well.
But, an overvalued RSI is common in a bull market (see early and mid-2024).
Our trigger to take that more seriously showed up in the On Balance Volume (OBV) chart (bottom section), which began to diverge (OBV not hitting new highs at the same time that the S&P hit new price highs) at the end of 2021.
That OBV divergence showed that new price highs were hitting the tape but that buying volume wasn’t backing them up.
Given the froth in the market and the return of meme stocks, market sentiment has an edge of “2021 everything bubble” to it these days.
And rising margin debt means that the risks of a downturn are more pronounced should things go south.
So, for the time being, enjoy the bull market (even though stocks are overvalued), just keep an eye on the chart so you’ll know when to pull in the reins a bit and build up some dry powder.
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