Advertisement
Valuation Indicators Show Reduced Market Overvaluation

Here is a weekend summary of the four market valuation indicators I regularly follow:
● The Crestmont Research P/E Ratio (more)
● The cyclical P/E ratio using the trailing
10year earnings as the divisor (more)● The Q Ratio, which is the total price of the
market divided by its replacement cost (more)● The relationship of the S&P Composite to
a regression trendline (more)To facilitate comparisons, I’ve adjusted the two P/E ratios and Q Ratio to their arithmetic means and the inflationadjusted S&P Composite to its exponential regression. Thus the percentages on the vertical axis show the over/undervaluation as a percent above mean value, which I’m using as a surrogate for fair value. Based on the latest S&P 500 monthly data, the market is overvalued somewhere in the range of 22% to 48%, depending on the indicator.
Three of the four indicators (Crestmont P/E, cyclical P/E and regression analysis) are showing a significant improvement (reduced overvaluation) from last month’s numbers. The Q Ratio remains elevated near last month’s level. However, as I pointed out in my separate Q commentary, the Flow of Funds data on which the Q Ratio based is increasingly stale. The new Flow of Funds report will be released on September 16th, at which time I’ll post a Q update.
I’ve plotted the S&P regression data as an area chart type rather than a line to make the comparisons a bit easier to read. It also reinforces the difference between the line charts — which are simple ratios — and the regression series, which measures the distance from an exponential regression on a log chart.
The chart below differs from the one above in that the two valuation ratios (P/E and Q) are adjusted to their geometric mean rather than their arithmetic mean (which is what most people think of as the “average”). The geometric mean weights the central tendency of a series of numbers, thus calling attention to outliers. In my view, the first chart does a satisfactory job of illustrating these four approaches to market valuation, but I’ve included the geometric variant as an interesting alternative view for the two P/Es and Q. In this chart the range of overvaluation would be in the range of 45% to 66%.
As I’ve frequently pointed out, these indicators aren’t useful as shortterm signals of market direction. Periods of over and undervaluation can last for years. But they can play a role in framing longerterm expectations of investment returns. At present they suggest a cautious longterm outlook and guarded expectations.
Note: For readers unfamiliar with the S&P Composite index, see this article for some background information.
Also, here is a link to the monthly valuation update from Jacob Wolinsky at ValueWalk.com.
From Market Valuation Overview.
Images: Flickr (licence attribution)
About The Author
My original dshort.com website was launched in February 2005 using a domain name based on my real name, Doug Short. I’m a formerly retired first wave boomer with a Ph.D. in English from Duke. Now my website has been acquired byAdvisor Perspectives, where I have been appointed the Vice President of Research.
My first career was a faculty position at North Carolina State University, where I achieved the rank of Full Professor in 1983. During the early ’80s I got hooked on academic uses of microcomputers for research and instruction. In 1983, I codirected the Sixth International Conference on Computers and the Humanities. An IBM executive who attended the conference made me a job offer I couldn’t refuse.
Thus began my new career as a Higher Education Consultant for IBM — an ambassador for Information Technology to major universities around the country. After 12 years with Big Blue, I grew tired of the constant travel and left for a series of IT management positions in the Research Triangle area of North Carolina. I concluded my IT career managing the group responsible for email and research databases at GlaxoSmithKline until my retirement in 2006.
Contrary to what many visitors assume based on my last name, I’m not a bearish short seller. It’s true that some of my content has been a bit pessimistic in recent years. But I believe this is a result of economic realities and not a personal bias. For the record, my efforts to educate others about bear markets date from November 2007, as this Motley Fool article attests.