Is The Stock Market Overvalued? What should you do?

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    The debate still rages on Wall Street regarding the stock market’s valuation right now. The market has soared since the historic 2009 low, but has recently been correction territory.

    There are many different ways to determine valuation and are mostly subjective because you have to make many assumptions about the future.

    Price/Earnings Ratio:

    The most common way to measure valuation is to use the price/earnings ratio (often shortened to the P/E ratio). The P/E ratio ratio is the price vs earnings.  It is natural to compare a company’s stock price to it’s earnings per share. For the broader indices such as the S&P 500, you can take the average earnings of the components within the index to calculate the earnings side of the equation and compare it to the price.

    Forward And Trailing:

    Many investors also look at the forward and/or trailing earnings. Each has a different outcome. Currently, the market’s forward P/E ratio is above 19X, which is above the historical average of 16X. According to Factset, earnings growth remains strong, especially before the tax reform bill passed in December 2017, which bulls may argue are reasons enough to justify higher valuations.

    What Are Well Known Investors Saying:

    Hedge fund billionaire, Leon Cooperman said that the stock market is not overvalued, or at least not right now. Cooperman said the market is “reasonably fully valued” and because interest rates are low, valuations are justified. However, lately interest rates have been on the rise and has worried many investors.

    Chad D. Roope, CFA Portfolio Manager – Fundamentum A Division of Stratos Wealth Partners, believes too that the market is not overvalued. He said, “With approximately $10 in additional earnings from tax reform, the S&P 500 is trading around 18 times forward earnings. Close to where we entered 2017 (approx. 17x). While earnings are less of a concern to us currently, what investors eventually pay for these earnings is a bigger concern, especially if inflationary pressures increase. A loss of a modest 1 multiple point due to inflation concerns is an approximate 6% hit to equities alone. Without the onset of inflation, we’d expect equities to hold the multiple it has entering the year which could make 2018 another outstanding year for equity investors given the expected earnings growth. ”

    James D. Hiles, ChFC and Partner, at First Capital Advisors Group, made a point about historic P/E levels. He said, “There are more high-growth stocks in the S&P 500 than ever before and that given the tectonic shift from tangible assets on corporate balance sheets, to intangible assets, by definition P/E ratios should be higher than the historic norm. Also, if you take the S&P 500’s average P/E starting in 1990 through January of this year it is 23.85x. Currently the S&P is trading at around 18.6x forward earnings. We would also note that four companies dominate the S&P 500, accounting for 10% of the index, and trade at an average P/E of ~29x earnings skewing the P/E to the higher side.”

    Not everyone is bullish:

    Sarah L. Jones, CIO, The Pintin Group, a private family office in Europe, believes the market is overvalued and the bullish trade is a crowded trade. Sarah thinks that valuations are exceeding the norm and is concerned that investors are simply following the trend mindlessly higher.

    Bradford Seagraves, CFA Investment Analyst, VP at Davenport Asset Management also believes the stocks in general are a little overvalued.

    He said, “I think the stock market is just modestly overvalued right now. While the P/E multiple is above the LT historical average, when viewed in the context of 1) continued low interest rates, 2) still incredibly accommodative monetary policy, and 3) a massive dose of fiscal stimulus in the form of the corporate tax cut, stocks still look pretty attractive. I think we remain in the sweet spot of the cycle for stocks. Most investors are is increasingly worried about valuation which only gives more life to this bull market. I think the surprise upside move YTD after a great year last year is indicative of these factors at play.”

    Is it always good to be a bull:

    If you go back and study historical prices and earnings, the market may be fully valued but not extremely overvalued.

    Even though the market is not “cheap” right now, it doesn’t mean it can’t continue to rally.

    “Bull markets are born on pessimism, grown on skepticism, mature on optimism and die on euphoria.  The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell” – John Templeton

    One analysis that gets missed is the Shiller P/E.  Similar to the regular P/E ratio, but the Shiller P/E adjusts for inflation.  Right now the Shiller P/E is 32X.  The only times in history that it was that high was before the great depression and during the dot com bubble.  The historical average for the Shiller P/E is 16.8X (see chart below).

    Shiller P/E 32 Market Overvalued

    Based on the Shiller P/E of 32X, the market’s implied return is expected to be -2.7%.  That’s right, a negative 2.7%.

    Conclusion:

    You be the judge, but I would be careful not to be too aggressive with your equity investments.  The best advice is to when you believe the market is fair valued or overvalued is to buy high-quality companies.

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    The founder of Trading News Now (TNN) and contributor to the stock market trading community. Graduated from Brigham Young University - Idaho with a degree in financial economics. Aside from his extensive knowledge in fundamental analysis of publicly traded companies, other interests include programming and financial modeling.