Stock market overpriced?

Still, we need to keep an eye on any stock market that is overpriced on unrealistic
expectations and irrational exuberance. Cross-border stock market contamination is always possible because of the fear factor. The U.S. stock markets are more deeply vulnerable to another danger — that foreigners increasingly shun U.S. equities as already fully valued, whereas other markets offer opportunities. The German DAX index, for example, is up by triple the amount of the S&P 500 since the beginning of the year, and more than double over the past two years (Table 1).

Over those two years, if you were a dollar-based investor, you got an additional 5.25 percent from being in the euro, which rose from 1.2885 to 1.3562 over the period. On the whole, we are accustomed to an environment in which the U.S. stock market leads the world. The correlation of other stock markets with the U.S. is quite remarkable, especially if you consider stock valuations “should” be based on earnings and other fundamentals. Why would a bounce in a U.S. index be mirrored in some other country’s index, where earnings and other fundamentals are different — and not even reported on the same schedule?

Figure 2 shows the DAX and the S&P 500, converted to show the percentage changes over the past 500 days. The two indices move in lockstep. Nowhere is this more evident than in the Nasdaq and the Nikkei 225, although this has some fundamental justification. The Nasdaq is full of hightech names that buy products (such as chip-making equipment) from the companies in the Nikkei. Higher sales and earnings by Nasdaq companies mean higher sales and earnings down the road for Nikkei companies (Figure 3).