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The Best Way To Gauge If The Market Is Overvalued

With the Standard & Poor’s 500 index advancing 12% during the first quarter of 2012 and up more than 25% since early October, worries about an overpriced market are growing. But how best to gauge whether shares have moved too high or still offer value to investors?
The standard measurement of market valuation compares earnings to share prices. To get the price-to-earnings ratio, or P/E, simply divide the price of a share of stock by the annual earnings per share. For the S&P 500 as a whole, this ratio is calculated by dividing the index level by the combined profits of all 500 companies. The P/E ratio also is commonly described as an earnings multiple—it indicates the price investors are willing to pay for each dollar of earnings.

But as simple as that sounds, one question immediately comes up. Should you compare stock prices to profits companies already have earned, or is it more helpful to look at projected earnings? And even after you decide whether to look backward or forward, you still have to choose a time frame. Typically, 12-month trailing earnings will be used to compare what companies have achieved, but some analysts and investors prefer longer time frames.

Yale University Professor Robert Shiller —best known for his book Irrational Exuberance, written at the height of the technology bubble—uses a 10-year trailing earnings model that he created. The model is known commonly as the CAPE model, for cyclically adjusted price-earnings. The model compares the inflation-adjusted or “real” price level of the S&P 500—adjusted according to changes in the Consumer Price Index, or CPI, a key inflation benchmark—to the 10-year moving average of trailing earnings. By taking that long view, Shiller can minimize the impact of shorter-term fluctuations in the business cycle.

According to the CAPE model, the current valuation of the S&P 500 is less than it was when the market peaked in 2000 and 2007—the first time because of the tech bubble and the second as a result of an overexuberant credit environment—but it’s near where the market was in 1966. After hitting that long-ago peak, stocks were basically flat for the next 16 years.

According to the long-term trailing CAPE model, the S&P 500 recently was trading at 22 times earnings—a level well above the CAPE model’s long-term average of 16. But independent economist Fritz Meyer considers the Shiller method flawed because it examines the past 10 years of market history, which have included two aberrant market troughs—2001 through 2003, after the tech bubble burst, as well as the 2008 crisis and ensuing recession.

Other tracking methods, meanwhile, generate less ominous numbers. If you use the more standard 12-month trailing earnings period, you get a P/E ratio of about 14, and if you use estimates for future earnings, the multiple is closer to 13.

How can you know which model to follow? Meyer suggests that going back to periods such as the 1950s and 1960s can help put things into perspective. During those decades, characterized by consistently benign inflation, the average P/E was 17.5 to 18. (Because the price-earnings equation factors in the CPI, looking at prices and earnings through the lens of inflation makes sense.) During the 1970s, inflation spiraled upward, peaking in 1980. But during the three following decades, inflation again was mild, at 2.5% to 3%, and the market multiple averaged 17. Compared with those periods of market history—and, again, using shorter-term trailing or forward earnings—the current S&P, though inflated by the recent rally, doesn’t seem overvalued.

There’s another aspect of recent market history that still may give investors pause, however. During the past two years, each time the forward-looking P/E has risen above 14, something bad has happened to rattle the stock market. In some cases, investors had to face indications that the U.S. recovery was flagging. In others, the market was rocked by fears about fallout from Europe’s sovereign debt issues or even by worries that the Eurozone might dissolve.

Each time, however, markets have sprung back, often aided by steps the U.S. Federal Reserve has taken to keep the economy going. Eventually, as growth in the U.S. gross domestic product accelerates, inflation also will pick up, and that’s likely to unsettle the stock market once again. Yet for now, Meyer believes that concerns about an overheated market are unfounded.



This article was written by a professional financial journalist for Legend Financial Advisors, Inc. and is not intended as legal or investment advice
.



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