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Is The Stock Market Overvalued?

December 07, 2009 | About:
Every day as the market sets new highs for the year, many pundits are commenting that the market is getting over valued. The pundits will cite current data, which shows that the P/E of the stock market is extremely high. Respected people including Bill Gross of PIMCO and Noureil Roubini are on TV on an almost daily basis proclaiming the market is over valued and about to have a large decline. Many of these pundits were also calling in early February of this year, for the Dow Jones to drop to 5,000 or even 3,000. Many of them who made wrong predictions then are confident enough to continue with their market timing forecasts.

I do not think anyone can accurately predict the short term movements of the stock market. Leaving that point aside lets assume like these "experts" that if the market is over valued it can be accurately predicted that it will decline soon. However, I do think it is accurate to call the market over valued due to current low earnings. The P/E is very high due to the worst earnings decline in history. It is not accurate to call the market over valued based on the past 12 months which by any standard was abnormal. If current P/E data is distorted, how then can it be ascertained what the current market valuation should be? I looked at six different metrics of market valuation to try to answer this question.

P/E TTM

On a TTM basis the S&P has a P/E of 87. (Current S&P value 1106 divided by last 12 months earnings of 12.72). Based on this data the market is significantly overvalued. However I do not think this is a fair way of valuing the market when considering the significant decrease in earnings over the past year. To get an accurate picture of whether the market is fair valued based on P/E ratio it is more accurate to take several years of earnings.

P/E 10 Year Average

The 10 year P/E ratio is currently 20.05. This number is based on Rober Shiller's data evaluating The average inflation-adjusted earnings from the previous 10 years. This is slightly over valued since the average P/E is around 15. However with interest rates at zero, the market should be trading at a slightly higher P/E than the historical norm. The market with an earning yield of about 5% looks much more attractive than 10 year treasury yields of 3.5%.

P/BV

The average Price over book value of the S&P over the past 30 years has been 2.4. Today, that number is about 2.33, showing the market is slightly under bought. Book value is considered a better measure of valuation than earnings by many investors including legendary investor Martin Whitman. He states that book value is harder to fudge than earnings. In addition book value is less affected by economic cycles than one year earnings are. P/BV therefore provides a longer term accurate picture of a company's value, than a TTM P/E.

US_Equity.jpg

Dividend Yield

The current dividend yield of the S&P is 2.29. T It is hard to determine on this basis whether the market is over priced. The dividend yield for stocks was much higher in the begging of this century than the later half. The dividend yield on the S&P fell below the yield on Ten-Year treasuries for the first time in 1958. Many analysts at the time argued that the market was over priced and the dividend yield should be higher than bond yields to compensate for stock market risk. For the next 50 years the dividend yield remained below the treasury yield and the market rallied significantly. In addition the dividend yield has been below 3% since the early 1990s. While I personally favor individual stocks with high dividend yields, I must admit that the current tax code makes it far favorable for companies to retain earnings than to pay out dividends. Finally, as I noted above the current economic environment has zero percent interest rates and low bond yields. During periods where yields are low it is logical for income oriented investors hungry for yield to be bid up the market , and dividend yields to decrease. I think it is hard to claim the market is over bought based on the low dividend yield.

Stock Market Capitalization as perccentage of GDP

Stock Market Capitalization as a percentage of GDP is another metric albeit less commonly used than other metrics, to value the market. The total stock market index has a current capitalization of about $11.34 trillion. This is 79% of GDP which is $14.2 trillion, this is close to the historical average. Between 75-90% market capitalization as percentage of GDP is a fair value, therefore at a current level of 79%, the stock market is fairly valued. Warren Buffett stated that market capitalization as a percentage of GDP is "probably the best single measure of where valuations stand at any given moment.”

Tobins Q

Another value of stock market valuation which is less commonly used than many of the above methods are the Tobins Q. Tobins Q is currently about .86. This would show that the market is slightly over valued. The Tobins Q's average over several decades of data about .72. In the past Tobin's Q has been a good indicator of future market movements. In 1920 the number was at a low of .33, the next nine years included phenomenal gains for the market. In 2000 Tobin's Q almost reached a record high of nearly 2, and the market declined subsequently about 50% by 2003.

To recap

1. P/E(TTM)- Extremely overvalued

2. P/E(10 year average)- slightly over valued

3. P/BV- Slightly Under valued

4. Divdend Yield- Indeterminate/ Fairly valued

5. Market value relative to GDP- fairly valued

6. Tobins Q-Slightly Over valued

In conclusion the market is definitely not extremely over valued based on the above data. However, the case can be made that stocks may be slightly over valued based. However the historical data fails to take into account current record low interest rates. Taking into account interest rates, the market seems to be fairly valued currently.

disclosure: none

About the author:

Jacob Wolinsky
My investment ideas have been inspired by many of value investors including Benjamin Graham, Charles Royce, John Neff, Joel Greenblatt, Peter Lynch, Seth Klarman,Martin Whitman and Bruce Greenwald. .I live with my wife and daughter in Monsey, NY. I can be contacted jacobwolinsky(AT)gmail.com and my blog is www.valuewalk.com

Visit Jacob Wolinsky's Website


Rating: 4.4/5 (31 votes)

Comments

gurufocus
Gurufocus premium member - 4 years ago
GuruFocus Market Indicator shows the market is fair valued.

Guru John Hussman uses Price to Peak PE to measure market valuation, he thinks the market is over valued. He had it right in 1999 and 2007.
kfh227
Kfh227 premium member - 4 years ago
Stock Market Capitalization as percentage of GDP is all there really is to it.

The second test is, when you value good stocks, where do their values fall? Fairly valued? under? over? If you are honest to yourself and value say 30 stocks, you can get an idea of where the markets are overall. When the Dow was 14,000 I had a hard time finding bargains. Being honest with yourself is a good measure also. I think I looked at over 50 stocks anyways in 2007 and the only bargain was JNJ ... which is still a bargain today. Alot of that sector was worth looking at in 2007 and is still the case today.

Today, I am finding most stocks to be fairly valued with a handful of bargains. I rarely run into stocks that are obviously overvalued. The bargains exist. Just do the due diligence.
DaveinHackensack
DaveinHackensack - 4 years ago
The 10 year P/E ratio is currently 20.05. This number is based on Rober Shiller's data evaluating The average inflation-adjusted earnings from the previous 10 years. This is slightly over valued since the average P/E is around 15.

First, a P/E of 20 isn't "slightly" higher than a P/E of 15, it's a third higher. Second the long-term market average P/E of 15 is an average over a hundred years of secular bull and bear markets; the average P/E has been significantly lower in secular bear markets. We are in a secular bear market.

However with interest rates at zero, the market should be trading at a slightly higher P/E than the historical norm. The market with an earning yield of about 5% looks much more attractive than 10 year treasury yields of 3.5%.

Apples and oranges. Investors often buy Treasuries for protection of principal (if they are going to hold them to maturity) or for their recent negative correlation to stocks and other risky assets. Also, "earnings yield" is a theoretical construct. You can spend the interest you earn on Treasuries; you can't spend "earnings yield". You can only spend what companies pay out as dividends.



Book value is Martin Whitman. He states that book value is harder to fudge than earnings.

Wouldn't that fudging be less of an issue when measuring market valuations in aggregate?

vooch
Vooch - 4 years ago
I'll just chime in and say, "kick the can"... since that's the general and predominant theme from what I've been reading lately. Heck, let's just "kick the can" a little further, and let someone else deal with the problem (that seems to be the current American mindset) later.

It's obvious, the dollar devaluation is also tied to the opposite...the U.S. stock market going up. Basically, the U.S. Government is confiscating wealth from an unsuspecting public during this period.

To hold cash, means you hold death, here.

From what I've seen, money is flowing into high-quality large caps in a big way - at too fast a pace, but every bubble goes way beyond expectations... we're just starting that one.

As for now, "the can" keeps getting "kicked" forward. At some point, it'll hit a wall, and look for a big correction when it hits. The can hasn't hit the wall yet, but we're watching for it.

I'm about 90% long, 1% short, and 9% cash.

- Vooch

Sivaram
Sivaram - 4 years ago
Dave: "Apples and oranges. Investors often buy Treasuries for protection of principal (if they are going to hold them to maturity) or for their recent negative correlation to stocks and other risky assets."

Actually the original author is likely correct in saying that the market will value things higher if interest rates were lower. Nothing in life is certain (especially if interest rates are distorted or if central banks are ordered by the government to monetize government debt) but, generally, valuations tend to be higher if interest rates are low. There are two ways I look at it.

One way is the one the original author presented. Namely, stocks compete against bonds and owning highly valued stocks is rational if bonds have low yields. Nowadays with cross-country capital flows, I'm not sure how perfect this is but I do think most investors stay within their local region.

Another way to look at it is from a theoretical point of view. If interest rates are expected to remain low for a long time, then stocks, which simply represents future cash flows discounted to the present, will be discounted at a lower rate. A company that earns, say, $1m per year for the next 30 years would be worth more right now if interest rates were 1% for the first 15 years than if rates were 5%.

There is practical evidence supporting the low-bond-yield=high-stock-valuation view. The best example is Japan. I forget the exact number but Japanese stocks have largely traded at P/Es above 25 throughout the 90's and (most of) 2000's. If you were a Japanese investor and didn't want to invest overseas, it is quite rational to buy stocks with P/E ratios of 20 to 30 because the opportunity cost (bonds) is very low.

Dave: "Also, "earnings yield" is a theoretical construct. You can spend the interest you earn on Treasuries; you can't spend "earnings yield". You can only spend what companies pay out as dividends.

This is irrelevant in my opinion. Except for some income-seeking investors who favour distributed income, many do not invest for dividends. What matters is the earnings of the company. Earnings yield is what matters. You can see this is true by noticing how low-yielding investments (such as technology companies) often have high valuations. I'm not talking about bubbles but long-term valuations of such companies. If investors mostly cared about dividends, utilities/consumer staples/etc would trade at higher valuations but that's rarely the case.

The perfect company for me--this is also Warren Buffett's view--is one that pays zero dividends, and instead re-invests all profits in high-return investments. There are two important reasons for this.

The first reason is because you can compound returns without paying taxes. Someone investing in a company that pays high dividends is paying double taxes.

The second reason is even more important: companies can generally re-invest profits with much higher return rates than most investors can. If you are a really good investor or can buy companies really cheaply (usually below book value or something) then this isn't true but for nearly all others, including above-average performers, it is hard to beat the company's internal returns. For example, Coca-Cola's ROE is around 20% and, roughly speaking, it can earn 20% on every dollar it invests into the business. If you got a dividend, you would have a hard time finding a company that earns 20% on each dollar. Remember, a company that can earn 20% on its internal investment would earn that, not just today and tomorrow, but for years and possibly decades. Even if you found an investment that earned 20%, you would have a hard time duplicating that over and over and over again, over the future years.

So, as far as I'm concerned, dividends are over-rated and undesirable unless you need income or don't trust management (if you don't trust management, why are you investing in the company in the first place?) Like I said, my perfect company would not pay any dividends.

DaveinHackensack
DaveinHackensack - 4 years ago
Actually the original author is likely correct in saying that the market will value things higher if interest rates were lower.

Pull up Vitaliy Katsenelson's thesis on secular markets. He shows empirically that the correlation between earnings multiples and interest rates is not consistent, i.e., there were times when we had low interest rates and low earnings multiples.

Namely, stocks compete against bonds and owning highly valued stocks is rational if bonds have low yields.

You are repeating a bit of conventional wisdom here, but I don't know if it's really true. Investors generally buy stocks and bonds for different reasons. How many here would sell their top stock holding and buy a Treasury bond if yields on the 10 year Treasuries went up 50bps?



What matters is the earnings of the company.


True, but earnings tend to be a lot less consistent than bond coupon payments. A stock that looks cheap based on its trailing earnings yield may look expensive six months from now when those earnings fall off a cliff.



Like I said, my perfect company would not pay any dividends.


I aim for capital appreciation generally when I invest in stocks myself, but given your description of your perfect company, how, exactly, would a bond compete for your affections? They are apples and oranges, no?
Sivaram
Sivaram - 4 years ago
Dave: "Pull up Vitaliy Katsenelson's thesis on secular markets. He shows empirically that the correlation between earnings multiples and interest rates is not consistent, i.e., there were times when we had low interest rates and low earnings multiples."

I agree that there isn't a strong correlation but I suspect this is due to factors such as govt forcing the central bank to monetize debt (eg. 1930's to 1950's), the existence of the gold exchange standard (pre 1933 in USA), existence of quasi-gold-exchange standard (1933 to 1971), and so on. It should also be noted that we don't have many sample points. Bond cycles are very long (as long as 30 to 40 years) so we just don't have any statistically significant data.

I know I'm not helping my case by saying all this, so you are right in some sense in saying one shouldn't follow the thesis being put forth. But at the same time, I would argue that your argument doesn't have much evidence either and one can't be confident ignoring the nature of the bond yields.

Dave: "You are repeating a bit of conventional wisdom here, but I don't know if it's really true. Investors generally buy stocks and bonds for different reasons. How many here would sell their top stock holding and buy a Treasury bond if yields on the 10 year Treasuries went up 50bps?"

I think, in aggregate, market participants do compare bonds against stocks. In the short term people may not appear to. Also, the huge bull market in stocks has clouded everyone's vision--after all, how many people (except retirees) even consider investing in any bond in the last few decades? I mean, even risk-averse pension funds are overloaded on stocks.

So, you may or may not compare a stock investment against a bond but the market as a whole does. In fact, my opinion (admittedly with little evidence) is that the huge bull market in stocks from 1982 to 2000 (and maybe 2007 depending on how you count) was driven by the falling bond yields. As yields fell, capital moved into stocks (and even if they didn't increase stock prices, they supported them--sort of like how Japanese stocks were always expensive in the 90's because declining bond yields supported the stocks to some degree.)

Anyway, I personally do look at stocks vs bonds. I never ended up investing in anything (unfortunately for me) but, for instance, during the crash over the last year, I have been evaluating junk bonds versus stocks. One of the hardest decisions was figuring out whether to invest in junk bonds or stocks. Admittedly this is not the same as treasury bonds; but lately, I am looking seriously at treasury bonds. I'm a contrarian and that's why I am looking at Treasuries. But mainstream (non-contrarian) investors would actually find stocks really attractive given how low yielding bonds are.

In a very crude sense, stocks are perpetual bonds with the special ability to increase/decrease the coupon. Or conversely, some bonds, such as a zero-coupon bond, is somewhat similar to a stock.

Dave: "True, but earnings tend to be a lot less consistent than bond coupon payments. A stock that looks cheap based on its trailing earnings yield may look expensive six months from now when those earnings fall off a cliff."

Yeah, the fluctuating earnings and irrational reactions is what creates opportunities for stock market investors. The only reason you can become really rich off the stock market is because of those irrational times and fluctuating earnings. But most long-term investors are looking at the long run. Even the super-growth investors investing in Apple or Amazon are investing based on their view of long-term earnings.

In any case, the overall market's aggregate earnings don't change much. For instance, ROE of American corporations have been consistently around 12%; sales growth has essentially mirrored GDP growth plus inflation. And so on. So the overall market's earnings are more stable and somewhat like bonds than what one might think.

Dave: "I aim for capital appreciation generally when I invest in stocks myself, but given your description of your perfect company, how, exactly, would a bond compete for your affections? They are apples and oranges, no?"

I'm just a newbie and obviously not successful so take it for what it's worth...

From my point of view, all assets are the "same." To me, there is little difference between a stock and a bond... or real estate... or gold... or commodities... or art... or collectibles...or whatever. The characteristics and the valuation requirements differ but the main thing I'm trying to do is to invest in something with the highest return with the lowest risk.

I am seriously looking at US Treasury bonds instead of stocks. Although one looks like an apple while the other resembles an orange, I'm trying to find the fruit that is sweet and costs the least. In this case, if you lean towards deflation like I do (I could be completely wrong for all I know), a Treasury bond is quite comparable to a stock. People might be aiming for, say, 10% real return on stocks. Well, deflationists might perceive a govt bond as producing similar returns (say 4% yield + 6% capital gains.)

In fact, what you are doing with your short selling of stocks is, in my eyes, investing in a different "asset class." Short selling individual securities (as opposed to the whole market) is uncorrelated with the market in the long run. Someone looking at bonds vs stocks is sort of doing the same thing. Why are you shorting a stock? I suspect it's for the same reason I am looking at Treasury bonds instead of stocks: we believe the potential returns are attractive for the given amount of risk.

batbeer2
Batbeer2 premium member - 4 years ago
Frankly, I don't care if the market is over-, under- or fairly valued. I just need one or two cheap stocks. Still, out of curiousity, I wonder what these metrics said about the market two years ago.

Does anyone have access to a similar analysis from 2007 ?
Sivaram
Sivaram - 4 years ago
batbeer2 Wrote: "I just need one or two cheap stocks. "

Talk about concentrated investing ;) Just one or two? Hey, I need 5 cheap stocks. What if Communist Barack Obama (according to some on the right, including one on this board who shall remain nameless to prevent retribution against him) seizes your company with no compensation? Or what if future American leader, Sarah "Warmonger" Palin (according to some on the left) seizes your company for the glory of the nation? There goes 50% of your portfolio ;)

batbeer2: "Does anyone have access to a similar analysis from > 2007 ? "

You can tell what the analysis in 2007 would have looked by looking at the referenced charts. Most of these analyses are simply summaries of what the chart says. These are all time charts so just look at what the data point was in 2007. Since I am macro-oriented, I follow these things and here is my impression of what was said around 2007:

Back in 2007, some believed that the market was overvalued and made little sense. However, most of these people were ridiculed and run out of town. The problem for many of them was that they said the same thing for almost the whole decade--and were wrong for a long time. For instance, P/E multiples, P/BV multiples, corporate profit margins, and so on, were high compared to history.

The problem with these analyses--one reason pure value-investors don't pay much attention--is that it can take a long time for things to mean-revert. The best example is not stocks but government bonds. The investment graveyard is filled with the corpse of many bond bears who were saying bond yields were too low all the way back in the late 90's (I wasn't around back then but that's my read of the situation.) People like Jim Grant thought the 2003 low in bond yields was the multi-decade low but were completely wrong. Similarly, many thought stocks were overvalued in 1995 but were "wrong" for many years.

This is why I keep suggesting that investors should know who they are and should not mix up strategies. For instance, I see many value investors starting to incorporate macro thinking into their strategies and this makes no sense whatsoever. What makese these guys & gals think that they are better at macro all of a sudden? For instance, it makes no sense to me how David Einhorn is one of the biggest gold bulls right now. Perhaps I'm biased because I'm bearish on gold (although I have no position) but I really wonder if he will be able to exit his position if gold starts gapping down (note: I'm not expecting that to happen any time soon but just pointing out how things could blow up so easily.)

anders
Anders - 4 years ago
!.. as far as I know its not the %age of gdp -- Its gnp..

Regards,

scubasteve10
Scubasteve10 - 4 years ago
Emerging markets are very overvalued. US markets are only overvalued by approx. 10% in my opinion. I believe when the risk trade unwinds that emerging markets will fall significantly.
batbeer2
Batbeer2 premium member - 4 years ago
Thanks for sharing your thoughts.

What if Communist Barack Obama ... seizes your company with no compensation?

Owning 50% fewer companies reduces that risk by 50%.

There goes 50% of your portfolio

You assume 100% annual turnover.

batbeer2
Batbeer2 premium member - 4 years ago
Good points all.

What if Communist Barack Obama (....) seizes your company with no compensation?[/i]The chances of that happening increase as you diversify. If one quantifies risk as:

risk = chance x impact

then advanced linear algebra dictates you can only reduce the risk by selecting the right stocks; diversification just doesn't help.

[i]Talk about concentrated investing ;) Just one or two?
You assume 100% turnover. One or two ideas with a 5% annual turnover gets you a large portfolio.

I admit I traded too much this year. I feel comfortable with ± 8 stocks. If I am to be consistent, I have to reduce my turnover to single digits. I'm working on it. Now I try to buy ONLY what I plan to hold for a decade or more. Still learning.
buffetteer17
Buffetteer17 premium member - 4 years ago
risk = chance x impact

That's a new one to me. What's your definition of "chance?" Probability of an outcome? How do you handle multiple outcomes? Sum up the probability of each x the impact of each? If you mean probability of specific outcome, then your conclusion does not follow. Simple counter-example:

Case 1. Flip a coin, lose $1 or win $1. Total risk = 50% x -1 + 50% x +1 = 0. That can't be right, are you saying there is no risk here at all? Let's try a specific outcome. Risk of losing some money, 50%.

Case 2. Flip two coins, lose $0.5 or win $0.5 per flip. Risk of losing some money, 25% since have to lose twice in a row. Seems like less risk than case 1 to me. The coin flips are not correlated.

Now if the coins were glued together, then the risk would be the same as case 1, because the flips would be perfectly correlated. It appears that one has to consider how correlated the stocks in a portfolio are, as well as the risk in individual stocks.

If I were to continue this line of thought I'd end up with Modern Portfolio Theory (MPT), dominant portfolios, efficient frontiers, Sharpe ratios and such, but enough for now. The trouble with all this beautiful theory is, of course, that nobody knows what the future correlations will be. Who would have thought that almost all correlations would go to the maximum last March?

batbeer2
Batbeer2 premium member - 4 years ago
What's your definition of "chance?" Probability of an outcome?

Hmmm.... yes. probability of outcome is what I meant.

How do you handle multiple outcomes?A very important question. Here goes:

Case 1.

For impact you used 1 and -1. I propose 0.9 and -1.1.

Here is my reasoning:

a) There are fees to consider.

b) More importantly, in practice, repeating the experiment, over time, will make 100% sure you end up with 0. Splitting your bets over multiple flips will only make sure you get to flip more often. It does not change the outcome. You are certain to end up with 0 over time.

So we must introduce a "cost of flipping" to make the simplistic model of reality less flawed.

Case 2

I propose to use 0.9; -0.55; -0.55; -1.1 for the four possible outcomes.

It appears that one has to consider how correlated the stocks in a portfolio are, as well as the risk in individual stocks.

Yes.

The investor needs some advantage in calling the flips. If you are 80% right 5% of the time your perfect portfolio should be smaller than the portfolio of the guy who is 55% right 80% of the time. The latter guy looks a lot like the guy without a clue. The guy without a clue should be in an index fund.



- EDIT -

I reread your post. Risk = probability of NEGATIVE OUTCOME x impact. You added risk and what I woud call upside potential and got zero. This DOES make sense. What you are playing is a zero sum game.

I propose to use -1.1x50% for risk. You add that to 0.9x50% for the upside and you end up with negative total. This translates to the stock market being a less than zero sum game for the average investor.
DaveinHackensack
DaveinHackensack - 4 years ago
The trouble with all this beautiful theory is, of course, that nobody knows what the future correlations will be. Who would have thought that almost all correlations would go to the maximum last March?This seems like a point in favor of long-short equity portfolios.

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