With the market down big time this morning there is no shortage of talk about this being the end of the current upswing. Yves Smith at naked capitalism cites a range of fundamental reasons why the market may be in for rougher times ahead. Zero Hedge passes along a note by Janet Tavikoli talking about going to 100% cash. Henry Blodget at The Money Game notes how this might be the end of the “sucker’s rally” we have been experiencing.
One thing we cannot say with confidence what the market is worth at any point in time. Each and every valuation method discussed out there has its drawbacks. For example, see this piece by Eddy Elfenbein at Crossing Wall Street on the vagaries of the earnings figure that goes in the P/E ratio. What we can say with some level of confidence that the market has moved from a state of undervaluation to either fair valuation or moderate overvaluation. Let’s take a look at some of the evidence for this.
John Hussman at Hussman Funds has been noting for some time now that the stock market, post-recovery, is overvalued. Especially when compared the state of the market coming out of a recession. Hussman writes:
Stocks are currently overvalued, which – if the recession is indeed over – makes the present situation an outlier. Unfortunately, since valuations and subsequent returns go hand in hand, the likelihood is that the probable returns over the coming years will also be a disappointingly low outlier. In short, we should not assume, even if the recession is ending, that above average multi-year returns will follow.
The guys at Bespoke Investment Group published (and now widely re-published) a graph that shows the S&P 500’s P/E ratio nearly doubling and returning to levels not seen since 2004. Their conclusion:
Obviously if the current bull is going to have any sustainability at all, earnings will have to start growing again. But for now, as evidenced by the skyrocketing P/E ratio, investors are paying up on the hopes of future earnings growth.
In the previously mentioned piece by Henry Blodget he shows a graph of the stock market being 10-15% overvalued based upon current normalized earnings.
One underutilized tool to keep an eye on is Morningstar.com’s Market Valuation Graph. It shows “market valuations based on Morningstar’s fair value estimates for individual stocks.” What it clearly shows is that the market, after having been profoundly undervalued back in November 2008, has come all the way back to fair value.
It is also helpful to step back and take a longer term look at this indicator. From this perspective you can see that the market has, since 2001, been more overvalued than it is today. One can also see just how cheap the market got back in 2008.
All of that being said, a glance at any of the above examples shows that the stock market can come unhinged from fair value, both overvalued and undervalued, for long stretches at a time. Therefore relying on P/E ratios and the like for precise timing signals is a mug’s game at best.
However traders can use the general state of market valuation as a backdrop. When the market is at a valuation extreme it can make sense to look at those trades that could very well take advantage of a return to more normal valuations. No one can say with extreme confidence where the market will go from here forward. However, given the evidence from the above graphs it is safe to say the easy money from the long side (for now) has already been made.