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Market Valuation Overview

I delayed posting this monthly update until we had yesterday’s release of quarterly Fed data for calculating the Q Ratio, which I’ve discussed in more detail in the Q Ratio commentary linked below.
Here is a summary of the four market valuation indicators I updated at the beginning of the month.
 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 price 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 55% to 90%, depending on the indicator, down slightly from the previous month’s 56% to 92%.
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 67% to 104%, down slightly from last month’s 69% to 106%.
The Average of the Four Valuation Indicators
The next chart gives a simplified summary of valuations by plotting the average of the four arithmetic series (the first chart above) along with the standard deviations above and below the mean.
At the end of last month, the average of the four is approaching 2SD above the mean and is about 5% below the 1929 peak.
Here is the same chart, this time with the geometric mean and deviations. The latest value of 84% is above the two standard deviation value of 83% and likewise closing in on the 1929 peak.
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 many years. But they can play a role in framing longerterm expectations of investment returns. At present market overvaluation continues to suggest a cautious longterm outlook and guarded expectations. However, at the today’s low annualized inflation rate and the extremely poor return on fixed income investments (Treasuries, CDs, etc.) the appeal of equities, despite overvaluation risk, is not surprising. For more on that topic, see my periodic update:
Note: For readers unfamiliar with the S&P Composite index, see this article for some background information.
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.