Is the Stock Market Overvalued?

June 28, 2018 Randall Bal  Printer Friendly

In my last article, I wrote about a simple but effective tool for determining if a stock is overvalued or undervalued. This time, I’d like to introduce another simple but useful metric for your consideration: the “True Value” ratio. When investing, it’s helpful to know how the market as a whole is valued. There are many different ways to think about market valuation and, for the most part, they are subjective. For this article, I will be using the most common metric, the P/E ratio. We often think of the P/E for individual companies, but it can be used to evaluate the entire market as well. Right now, bears argue that the stock market is overvalued and the bulls believe valuations are justified and the market has more room to rally. Let’s see what the True Value ratio tells us.

Price/Earnings Ratio for the S&P 500

The most common way to measure valuation is to use the price/earnings ratio (often shortened to the P/E ratio or the PE). The P/E ratio looks at the current price versus a company’s earnings. For an individual stock, this is done by dividing a company’s stock price by its earnings per share (EPS). For the broader indices, one can look at the combined earnings of all the components within the index to calculate the earnings side of the equation and compare it to the index price.

Multpl.com does this for us for the S&P 500 index. Below is a graph of the P/E for the S&P 500. The P/E is based on trailing twelve month “as reported” earnings, going all the way back to 1871. Here is a table version of the same information, if you want to see the P/E for a particular year.

As you can see the mean (i.e., average) P/E for the S&P 500 since its beginning is 15.70. If we view this average as a marker of a fair or “true” valuation (more on that later), we can then use it as a basis to determine whether the current market is overvalued or undervalued. This is called finding the “True Value” ratio.

If we take the average (15.70) and divide it by the current S&P P/E (24.56) we get a True Value of 0.639.

Current S&P P/E ratio	24.56
Long Term S&P average P/E	15.70
“True Value” ratio	0.639

This ratio is a way to adjust the current market valuation to what it “should be” based on the long term average market valuation. The idea here is reversion to the mean—the market is likely at some point to return to its long term average valuation.

How to interpret the “True Value” number?

• A value of 1 is a fair value (i.e., the current P/E is the same as the lifetime average)
• A value less than 1 represent overvaluation
• A value higher than 1 represent undervaluation

If we still want to trade in an overvalued market, we can proceed with caution. For example, if you have a portfolio of $200,000 of domestic stocks you can calculate the “true value” of your investments (that is, what their price would be at the stock market’s long-term average valuation), you simply multiply the value of your investments by the True Value ratio. For example, your total portfolio of domestic stocks is worth $200,000 at today’s valuation, you should use the value of 0.639 * $200,000 = $127,800 for your planning.

Alternatively, from a risk management perspective if you have a $100,000 account and you would like to invest 5% of your portfolio by purchasing a domestic stock, you would be more conservative to invest not $5,000 but $5,000 * 0.639, or $3,195.

More Factors to Consider

Let’s compare True Value ratios over time. Although the current True Value number tells us the market is overvalued, it’s useful to see how this number has changed in a more recent market context, where historically lower interest rates have resulted in correspondingly higher market P/E ratios.

Additionally, while the lifetime average P/E of the S&P 500 does gives us a benchmark for value, it is worth noting that interest rates are in general lower than they used to be and stocks are perceived to be slightly less risky than they used to be due more stringent regulations and accounting requirements. Thus, the S&P 500 may be slowly shifting toward a higher mean valuation.

Here is the True Value ratio from each month over the last year:

Date	P/E	“True S&P Value”
28-Jun-18	24.56	0.639
1-Apr-18	23.97	0.655
1-Mar-18	24.60	0.638
1-Feb-18	24.62	0.638
1-Jan-18	25.39	0.618
1-Dec-17	24.25	0.647
1-Nov-17	23.81	0.659
1-Oct-17	23.67	0.663
1-Sep-17	23.28	0.674
1-Aug-17	23.16	0.674
1-Jul-17	23.36	0.672
1-Jun-17	23.40	0.671
1-May-17	23.31	0.674

And here is the True Value ratio over the last 5 years:

Date	P/E	“True S&P Value”
28-Jun-18	24.56	0.639
1-Jun-17	23.40	0.671
1-Jun-16	23.97	0.655
1-Jun-15	22.12	0.710
1-Jun-14	18.88	0.832
1-Jun-13	17.80	0.882

Note that all of these are calculated with the current P/E mean of 15.7, which is probably very close but not exactly the same as it was five years ago. This does not affect our analysis, but it’s worth noting that if you were to have calculated the “True S&P Value” on June 1, 2013, you might have come up with a slightly different value.

What do we see in these tables? There is certainly a clear downward trend in the ratio, meaning that the market—while never a “fair value” in this period—has gotten more expensive.

Another factor to consider is the risk premium of stocks, i.e., the spread between the earnings yield of the S&P 500 and “risk-free” yield of 10-year treasury notes. If the risk premium is high, it means they are getting paid more to take risk in the market; if the risk premium is low, investors are paid less to take risk, and therefore the incentive to invest in stocks is lower. Here is a table of risk premiums over the last five years (note that the 2018 values are estimates; data also from multpl.com):

Date	S&P 500 Earnings Yield	10-Year “Risk Free” T-Note Rate	Spread (Risk Premium)
28-Jun-18	4.07%	2.83%	1.24%
1-Jan-18	3.94%	2.58%	1.36%
1-Jan-17	4.24%	2.43%	1.81%
1-Jan-16	4.51%	2.09%	2.42%
1-Jan-15	4.99%	1.88%	3.11%
1-Jan-14	5.51%	2.86%	2.65%
1-Jan-13	5.87%	1.91%	3.96%

What we see here is that the risk premium has dropped significantly since 2013. So not only is the market expensive when looking at the P/E and True Value ratio, but it is also “less of a good deal” than it used to be when compared to relatively risk-free US 10-Year Treasury bonds, whose yields have increased slightly.

Where does this leave us?

The market is expensive right now, that is clear. However I would argue that, while this market is fully valued, it is not egregiously overvalued. With the interest rate increases, the valuation of the market is definitely concern, but the bull argument is the rates aren’t going to rise much more and market earnings growth has been robust and is expected to continue. That will make the “E” part of the equation a lot bigger in the future. Furthermore, in bull markets (present market included), surprises tend to happen to the upside, not the downside. So, just because the market is not “cheap” right now, doesn’t mean it can’t continue to rally. It does mean however that you’ll want to be extra careful selecting quality stocks for long-term gains—Stock Rover has numerous tools that can help you do just that.

Good Trading!

Comments

None of this takes into account STOCK BUYBACKS by companies who try to push up their share price while rewarding existing stockholders. The Trump tax relief plan has led to massive buybacks, but it has had less effect on wages or hiring. Buybacks render the TRUE S&P Value … suspect if not false. It should not be too hard to included a “buyback algorithm” in your otherwise sound approach.

Reply

The PE has become almost useless as a comparison tool due to all the outrageous stock buybacks currently going on. BACK those out and you will be a real overvalued market

Reply

you should look at a forward blended est true value – ie ( 5yr trend + p/forward e )/2 rel , as in long run mkt reflects co’s eps (ok if u want discount a bit the analyst forward est as a risk factor) BIZ current price reflects a discounted forward expectation –

Then let us know what that number looks like (I’d guess closser to 1 than ur .6 number)

Reply

Excellent in its simplicity. Thank you.

Reply

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