Stock Market Valuation August 1, 2011

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Aug 02, 2011
I started this monthly market valuation series in December 2009. The reason for it was I was getting tired of hearing that the market was overvalued because P/E TTM was 87. This was ridiculous because earnings were deflated by the worst economic crash since the great depression. However, the question was how to value the market from a purely quantitative methodology, while ignoring all the outside noise and macro predictions of where the economy is headed. I looked for several different metrics to evaluate the market which over time have proven to be effective and decided to look at all the metrics, instead of just focusing on the last 12 months of earnings.

I was contemplating only updating the valuations on a quarterly basis, since why is there a need every month? However, since the market was and in general continues to be quite volatile, I consider it useful to evaluate on a monthly basis. When volatility truly gets to lower levels, it will suffice to update this series on a quarterly basis.

The current level of the S&P500 is 1,287, and the Dow is at 12,123 – slightly lower than last month. As evidenced below, market valuations did not change much over the last month.

The point of this article is to measure the stock market based on seven different metrics. As stated above, this article does not look at the macro picture and try to predict where the economy is headed. It only uses these several metrics which have been very good past indicators, or are widely used to determine whether the market is fairly valued.

I collaborate with two colleagues of mine for some of the data in this article, Doug Short of Dshort, my friend who runs Seeking Delta (who recently changed jobs, and unfortunately no longer updates his sites), and Josh of Multipl. All are great sites, and I encourage readers to check them out.

As always, I must mention that just because the market is over or undervalued does not mean that future returns will be high or low. From the mid to late 1990s the market was extremely overvalued and equities kept increasing year after year. However, as I note at the end of the article I expect low returns over the next 10 years based on current valuations. In addition, individual stocks can be found that will outperform or underperform the market regardless of current valuations.

To see my previous market valuation article from last month click here.

Below are eight different market valuation metrics as of August 1, 2011:

The current P/E TTM is 15.6, which is slightly lower than the TTM P/E of 15.8 from last month (This specific data is from the market close, July 29, 2011).


This data comes from my colleague Doug Short of

Based on this data the market is fairly valued. However, I do not think this is a fair way of valuing the market since it does not account for cyclical peaks or downturns. I only include P/E TTM because it is so widely used by the media and investors. However, look at the chart above and numbers below from previous market bottoms and it is clear that the metric is not accurate (see highlights below). Since 1950, the P/E TTM has only been in single digits range at the market bottom in 1974 and 1982. This is 2/8 or 25% accuracy. It astonishes me that the media still uses this metric so widely.

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.

Numbers from Previous Market lows:

March 2009 110.37

March 2003 27.92

Oct. 1990 14.21

Nov 1987 14.45

Aug 1982 7.97

Oct 1974 7.68

Oct 1966 13.96

Oct 1957 12.67

Jun 1949 5.82

Apr 1942 7.69

Mar 1938 10.63

Feb 1933 14.92

July 1932 10.16

Aug 1921 14.02

Dec 1917 5.31

Oct 1914 14.27

Nov 1907 9.35

Nov 1903 11.67

Historic data courtesy of []

Current P/E 10 (Shiller) Year Average 22.74 lower than 23.67


The current 10-year P/E is 22.74; this is lower than the P/E of 23.67 from the previous month. This number is based on Robert Shiller’s data evaluating the average inflation-adjusted earnings from the previous 10 years. Robert Shiller stated in an interview recently that he believes the S&P500 will be at 1,430 in 2020. Shiller believes that based on his metric the market is overvalued, and will offer subpar returns over the next 10 years. This number in my humble opinion is in the danger zone. I think it is important to think of P/E in terms of earnings yield. So at 22.74 P/E you are getting a 4.4% earnings yield, not very attractive.

The Shiller PE is my favorite metric; it has been a phenomenal predictor of future returns, except for a five year period from 1995-2000, where the stock market just kept going up and up. Besides for 2003 and 1966, the market bottom since 1903 was always below the mean of 16.40. Additionally, the metric is a great predictor of market tops. While PE TTM was ~15 in 2007 at the height of the bubble, the Shiller P/E was over 22, indicating dangerous territory.

Ironically, it is likely easier to forecast market returns over the next 10 years than it is for tomorrow. Based on my colleague, Rob Bennett’s market return calculator, the returns of the market should be as follows based on the current Shiller P/E:

Stock MarketBest PossibleLuckyMost LikelyUnluckyWorst Possible
10-Year Percentage Returns8.385.382.38-0.62-3.62
20-Year Percentage Returns7.485.483.481.48-0.52
30-Year Percentage Returns8.
40-Year Percentage Returns7.216.315.414.413.41
50-Year Percentage Returns7.236.435.634.934.23
60-Year Percentage Returns7.667.016.365.765.16
My colleague Doug Short thinks the Shiller’s numbers are a bit inaccurate because the number I used does not include the past several months of earnings, nor revisions. Doug calculates P/E 10 at 22.7, still by no means cheap (these numbers are from the market close July 29, 2011).


Mean: 16.40

Median: 15.78

Min: 4.78 (Dec 1920)

Max: 44.20 (Dec 1999)

Numbers from Previous Market lows:

Mar 2009 13.32

Mar 2003 21.32

Oct 1990 14.82

Nov1987 13.59

Aug 1982 6.64

Oct 1974 8.29

Oct 1966 18.83

Oct 1957 14.15

June 1949 9.07

April 1942 8.54

Mar 1938 12.38

Feb 1933 7.83

July 1932 5.84

Aug 1921 5.16

Dec 1917 6.41

Oct 1914 10.61

Nov 1907 10.59

Nov 1903 16.04

Data and chart courtesy of []

Current P/BV ?


I am unclear about what the current P/B value is. I thought the metric would be great for figuring out market returns because as Tweedy Browne and David Dreman demonstrate through extensive research, a basket of the lowest P/B stocks over long periods of time dramatically outperforms the market. It therefore would make sense that the P/B metric would be useful for evaluating the market itself in terms of over-valuation or undervaluation.

The main reason is that I saw that Horizon Asset management used the same numbers for P/B provided by Standard and Poors and come up with a whopping 3.68% (for April), according to the same numbers that I used I came up with closer to 2.10%. The number that I used, I obtained using data from the spy ETF, and updated using the latest change in the price of spy. This number will therefore not be 100% accurate since the book value has likely changed (slightly) since the numbers were last updated on June 31. But that does not account for the whopping difference between Horizion’s numbers and mine. A colleague of mine got very similar numbers to me for price over book. I am going to contact Horizon to see if I can reconcile the differences.

Unfortunately, there is very little data regarding P/B. I have been able to find close to no historic data on the metric. Additionally, my number was always an outlier which made me suspect my numbers might be wrong. I even had a Ph.D. student contact me to ask if there was any data available on price/book. I told him no! If you are reading this and have any data I would be grateful if you sent it over.

The average price over book value of the S&P over the past 30 years has been 2.41. 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 (although book value can easily be distorted). 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. I will continue my search for PB numbers.

Current Dividend Yield 1.82


The current dividend yield of the S&P is 1.82. This number is slightly above the 1.78 yield from last month. The number is not so low considering the 5 year treasury is yielding 1.32%. Compared to the ten year yield the numbers also look attractive. The dividend yield on the S&P 500 is less than 100 basis points lower than the 10 year. Both numbers though are far below their averages.


For attractive yield check out my recent article about Australian debt-

Although the number is low compared to previous numbers it has not been a great indicator of market returns. For the last four market lows since 1990, the dividend yield has been below the mean and medium every single time. In 2003, it was at 1.92 when the market bottom; significantly below the mean of 4.34%.

Additionally, it is hard to determine on this basis alone whether the market is overpriced. 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 overpriced 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 overbought based on the low dividend yield.

Mean: 4.34%

Median: 4.28%

Min: 1.11% (Aug 2000)

Max: 13.84% (Jun 1932)

Numbers from Previous Market lows:

Mar 2009 3.60

Mar 2003 1.92

Oct 1990 3.88

Nov1987 3.58

Aug 1982 6.24

Oct 1974 5.17

Oct 1966 3.73

Oct 1957 4.29

Jun 1949 7.30

Apr 1942 8.67

Mar 1938 7.57

Feb 1933 7.84

July 1932 12.57

Aug 1921 7.44

Dec 1917 10.15

Oct 1914 5.60

Nov 1907 7.04

Nov 1903 5.57

Data and chart courtesy of []

Market Cap to GDP is currently 93%, which is lower than95.2% from last month.

Ratio = Total Market Cap / GDPValuation
Ratio< 50%Significantly Undervalued
50%< Ratio< 75%Modestly Undervalued
75%< Ratio< 90%Fair Valued
90%< Ratio< 115%Modestly Overvalued
Ratio > 115%Significantly Overvalued
Where are we today (08/01/2011)?Ratio = 93%, Modestly Overvalued

In his 2001 Fortune magazine article, Warren Buffett used the ratio of the market value of all US publically traded securities to Gross National Product (GNP) as a yardstick to measure the stock market valuation. He stated that ”The ratio has certain limitations in telling you what you need to know. Still, it is probably the best single measure of where valuations stand at any given moment”. He further went on to say ”If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200%–as it did in 1999 and a part of 2000–you are playing with fire”.

According to Barron’s the ratio got as low as 40% in the late 1940s, when investors feared another depression, and in the inflationary 1970s.

Historic Data:

Min 35% in 1982

Max 148% in 2000

Guru Focus Data

GuruFocus calculates that the market will only return 4.3% over the coming years. The methodology is explained below:

1. Business growth

If we look at a particular business, the value of the business is determined by how much money this business can make. The growth in the value of the business comes from the growth of the earnings of the business growth. This growth in the business value is reflected as the price appreciation of the company stock if the market recognizes the value, which it does, eventually.

If we look at the overall economy, the growth in the value of the entire stock market comes from the growth of corporate earnings. As we discussed above, over the long term, corporate earnings grow as fast as the economy itself.

2. Dividends

Dividends are an important portion of the investment return. Dividends come from the cash earning of a business. Everything equal, a higher dividend payout ratio, in principle, should result in a lower growth rate. Therefore, if a company pays out dividends while still growing earnings, the dividend is an additional return for the shareholders besides the appreciation of the business value.

3. Change in the market valuation

Although the value of a business does not change overnight, its stock price often does. The market valuation is usually measured by the well-known ratios such as P/E, P/S, P/B etc. These ratios can be applied to individual businesses, as well as the overall market. The ratio Warren Buffett uses for market valuation, TMC/GNP, is equivalent to the P/S ratio of the economy.

What Returns Is the Market Likely to Deliver From This Level?

Putting all the three factors together, the return of an investment can be estimated by the following formula:

Investment Return (%) = Dividend Yield (%)+ Business Growth (%)+ Change of Valuation (%)

The first two items of the equation are straightforward. The third item can be calculated if we know the beginning and the ending market ratios of the time period (T) considered. If we assumed the beginning ratio is Rb, and the ending ratio is Re, then the contribution in the change of the valuation can be calculated from this:


The investment return is thus equal to:

Investment Return (%) = Dividend Yield (%) + Business Growth(%) + (Re/Rb)(1/T)-1

This equation is actually very close to what Dr. John Hussman uses to calculate market valuations. From this equation we can calculate the likely returns an investment in the stock market will generate over a given time period. In the calculation, the time period we used was 8 years, which is about the length of a full economic cycle. The calculated results are shown in the final chart to the right. The green line indicates the expected return if the market trends towards being undervalued (TMC/GNP=40%) over the next 8 years from current levels, the red line indicates the return if the market trends towards being overvalued (TMC/GNP=120%) over the next 8 years. The brown line indicates the return if the market trends towards being fair-valued (TMC/GNP=80%) over the next 8 years.

The thick light blue line in the bottom right chart is the actual annualized return of the stock market over 8 years. We can see the calculations largely predicted the trend in the returns of the stock market. The swing of the market’s returns is related to the change in interest rates.

It has been unfortunate for investors who entered the market after the late 1990s. Since that time, the market has nearly always been overvalued, only dropping to fairly valued since the declines that began in 2008. Since Oct. 2008, for the first time in 15 years, the market has been positioned for meaningful positive returns.

Data and charts courtesy of

Current Tobin’s Q 1.09 (data as of market close July 29th, 2011)


Tobins Q is 1.09, slightly lower than 1.19 from last month.



What is Tobins Q?

Here is a brief explanation from

A ratio devised by James Tobin of Yale University, Nobel laureate in economics, who hypothesized that the combined market value of all the companies on the stock market should be about equal to their replacement costs. The Q ratio is calculated as the market value of a company divided by the replacement value of the firm’s assets:


Investopedia explains Q Ratio (Tobin’s Q Ratio)

For example, a low Q (between 0 and 1) means that the cost to replace a firm’s assets is greater than the value of its stock. This implies that the stock is undervalued. Conversely, a high Q (greater than 1) implies that a firm’s stock is more expensive than the replacement cost of its assets, which implies that the stock is overvalued. This measure of stock valuation is the driving factor behind investment decisions in Tobin’s model

As can be seen from the above charts, the market is significantly over-valued based on tobins Q.

The data comes from Doug Short. This is the most accurate data that is available. It is impossible for the data to be 100% precise because the Federal Reserve releases data related to Tobin’s Q on a quarterly basis. The best that can be done is to extrapolate the data and try to provide the most accurate data possible based on the change in the Willshire 5000. This is what Doug and I did to get the current number. This method has proven extremely accurate for calculating Tobins Q on any given day.

The current level of 1.19 compares with the Tobins Q’s average over several decades of data of approximately .72. This would indicate that the market is extremely overvalued.

In the past Tobin’s Q has been a good indicator of future market movements. In 1920 the number was at a low of .30, 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.

Historic Tobins Q:

Market Low 1932: 0.30

Market High 1929: 1.06 (This is not the highest number ever reached, just the number reached before the 1929 crash.)

Average historic Tobins Q .72 (source: Stocks for the Long Run by Jeremy Siegel)

AAII Sentiment:

Sometimes market sentiment is the best way to measure future returns. Usually when the retail investor is bullish it is a contrarian sign to be fearful, and when they are bearish it is a sign to be bullish. The sentiment has proven remarkably accurate, the numbers below from previous market bottoms confirm this fact. For example in 2009, 70% of investors were bearish. The broad stock market is up ~100% since then.

The AAII Investor Sentiment Survey measures the percentage of individual investors who are bullish, bearish, and neutral on the stock market for the next six months; individuals are polled from the ranks of the AAII membership on a weekly basis. Only one vote per member is accepted in each weekly voting period.

AAII sentiment survey data from 7/27/2011

37.8% Bullish

30.7% Neutral

31.4% Bearish

Individual investors are not very bullish, a large % are neutral, this indicates normal valuations.

Long-Term Average:

Bullish: 39%

Neutral: 31%

Bearish: 30%

For all historic data on the AAII survey back to 1987 click on the following link- the collaboration of my colleague of I have now added a seventh metric for valuing the market. This data comes from the survey conducted by the American Association of Individual Investors (AAII) conducted on a weekly basis. According to the AAII, “The AAII Investor Sentiment Survey measures the percentage of individual investors who are bullish, bearish, and neutral on the stock market for the next six months; individuals are polled from the ranks of the AAII membership on a weekly basis. Only one vote per member is accepted in each weekly voting period.”

(Note: Seeking Delta has stop updating his site, and these charts are a bit outdated)


Below is AAII data from previous market bottoms (the AAII began the survey in 1987).The charts essentially show that on average, returns have been more favorable when bullish sentiment is below 28% vs above 50%. The one-year average return when sentiment is above 50% is 1.9% vs. 13.6% when sentiment is below 28%.



Bullish Neutral Bearish

March 2009 18.92% 10.81% 70.27%

March 2003 34.3% 14.30% 51.40%

Oct. 1990 13.00% 20.00% 67.00%

Nov. 1987 31.0% 41.00% 28.00%

Average 39.00% 31.00% 30.00%

Max 75.00% 62.00% 70.00%

Min 12.00% 8.00% 6.00%

Chart and data courtesy of

GMO Chart:

GMO: 7 Year stock market returns

To recap

1. P/E (TTM) – Fairly Valued 15.6

2. P/E 10 year – Extremely overvalued 22.74

3. P/BV – Extremely overvalued - 3.68 (using numbers discussed above from April)

4. Dividend Yield – Indeterminate/ overvalued 1.82

5. Market value relative to GDP – Moderately Overvalued 93

6. Tobins Q – Extremely overvalued 1.09

7. AAII Sentiment – Investors are neutral, market is fairly valued.

8. GMO – Overvalued

In conclusion, the market is overvalued based on the above data. Tobins Q, Shiller PE and PB data are all indicating that investors are too bullish and valuations are too high.

However, the historical data fails to take into account current record low interest rates. I know not many investors take issue with my inclusion of interest rates in the equation. However, I think that investors should look at the stock/bond alternative. Right now you can get some blue chip stocks with dividend yields close to the Ten year treasury yield.

However, eventually the market will likely returns to normal valuation ratios as interest rates reach more normal levels. I believe returns over the next 10 years will be sub-par (far below the 9.5% average market return). I think we will likely see returns equal to inflation over the coming decade.

You can read more about my predictions in the following two articles:

What Will The S&P 500 Return Over The Next 10 Years Part I

What Will The S&P 500 Return Over The Next 10 Years Part II

Note: I have received numerous suggestions on how to improve my monthly series. I tried to incorporate these ideas in my current article. Please leave a comment if you would like to provide further suggestions, I plan on significantly improving this article for next month.

Stay tuned till the beginning of next month for the next monthly valuation article.

Valuing Wall Street: Protecting Wealth in Turbulent Markets by Andrew Smithers. The book explains in detail how tobin’s Q is calculated.

Wall Street Revalued: Imperfect Markets and Inept Central Bankers. A more recent book by Andrew Smithers.

Irrational Exuberance by Robert Shiller. Great book by the man who calculates the P/E 10 ratio himself; Robert Shiller. The book is written in 2000, right before the tech bubble crash. Shiller correctly predicts the crash. Shiller also accurately predicted the housing bubble.