Logo Background RSS

Advertisement

Market Remains Overvalued

  • Written by Syndicated Publisher No Comments Comments
    July 8, 2017

    Here is a summary of the four market valuation indicators we update on a monthly basis.

    • The Crestmont Research P/E Ratio (more)
    • The cyclical P/E ratio using the trailing 10-year 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, we’ve adjusted the two P/E ratios and Q Ratio to their arithmetic means and the inflation-adjusted 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 we’re 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 115%, depending on the indicator, up from the previous month’s 56% to 113%.

    We’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.

    Standard Deviations

    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 increases our attention to outliers. In our view, the first chart does a satisfactory job of illustrating these four approaches to market valuation, but we’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 129%, up from last month’s 68% to 126%.

    Geometric Standard Deviations

    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 86% — unchanged from the previous month and at the interim peak.

    Standard Deviation Average

    Here is the same chart, this time with the geometric mean and deviations. The latest value of 96% was also unchanged from last month and at its interim peak.

    Geometric Standard Deviation Average

    As we’ve frequently pointed out, these indicators aren’t useful as short-term signals of market direction. Periods of over- and under-valuation can last for many years. But they can play a role in framing longer-term expectations of investment returns. At present, market overvaluation continues to suggest a cautious long-term outlook and guarded expectations. However, at 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 our periodic update:

    Market Valuation and Actual Subsequent 10-Year Total Returns

    Many of our readers have requested we reproduce a chart by John Hussman that inverts the S&P 10-year total returns. Hussman says “the most reliable correlation between valuations and subsequent returns is on a 12-year horizon, which is the point where the autocorrelation profile of valuations typically hits zero.” The correlation of valuations Hussman uses for comparison are at about 90%.

    You will notice that nominal returns are used – this is a direct result of a sort of Fisher-effect in which inflation ends up being washed out of the calculation. The nominal growth rate of the economy is highly correlated with the level of interest rates, but also negatively correlated with market valuations, all over the same time period.

    Here are the Geometric Average of the Four again and the recreated Hussman charts together.

    Points of ‘secular’ undervaluation such as 1922, 1932, 1949, 1974 and 1982 typically occurred about 50% below historical mean valuations, and were associated with subsequent 10-year nominal total returns approaching 20% annually. By contrast, valuations similar to 1929, 1965 and 2000 were followed by weak or negative total returns over the following decade. That’s the range where we find ourselves today. Of course, we also won’t be surprised if the S&P 500 ends up posting weak or negative total returns in the 2007-2017 decade, which would require nothing but a run-of-the-mill bear market over the next couple of years. – John Hussman

    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 co-directed 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.
    Share on FacebookTweet about this on TwitterShare on Google+Share on LinkedInPin on PinterestShare on StumbleUponShare on RedditShare on TumblrDigg thisBuffer this pageFlattr the authorEmail this to someonePrint this page

Advertisement

Closed Comments are currently closed.