Is the S&P 500 Overvalued?

The Dow Jones, S&P 500 and Nasdaq-100 are trading at new all-time highs. This makes stocks more expensive, but are stocks too expensive and overvalued? Here is a look at four different valuation metrics.

Is the S&P 500 overvalued? If you ask three analysts, you’ll probably get three different answers.

How can that be? Analysts often have different biases, and quote the valuation metric that boost’s their outlook.

Here’s a look at four different valuation metrics, which includes one ‘un-fudgeable’ value gauge and one that could be considered worthless (this also happens to be the most popular one).

Each valuation metrics is plotted against the S&P 500 (time frame: from 1881 – 2013).

Valuation Metric #1: 12-month Trailing P/E

Figure 1 shows the S&P 500 P/E ratio based on 12-month trailing ‘as reported’ earnings.

As of December 31, the 12-month trailing as reported P/E was at 18.19 (19.37 today).

The 134-year average is 15.81. The highest reading was 123.79 (May 2009), the lowest reading was 5.31 (December 1917).

Based on this P/E metric, the S&P 500 (SNP: ^GSPC) is 22.5% overvalued (compared to its 134-year average).

Valuation Metric #2: Cyclically Adjusted P/E

Figure 2 shows the S&P 500 Cyclically Adjusted P/E ratio (CAPE). The CAPE is based on average inflation-adjusted earnings from the previous 10 years (formula: take the annual EPS of S&P 500 for the past 10 years. Adjust EPS for inflation using the CPI. Take the average of inflation adjusted EPS figures over the 10-year period. Divide the current level of the S&P 500 by the 10-year average EPS).

As of December 31, the CAPE was at 24.86 (26.11 today).

The 134-year average is 16.61. The highest reading was 44.20 (December 1999), the lowest reading was 4.78 (December 1920).

Based on the CAPE, the S&P 500 (NYSEArca: SPY) is 57.2% overvalued.

Valuation Metric #3: Forward (Imaginary) P/E

The forward P/E is based on forecasted (or projected) earnings. Wall Street analysts are generally optimistic and most optimistic towards market peaks. As such, earnings forecasts are often inflated, resulting in depressed P/E ratios.

The current S&P 500 P/E based on projected earnings is 18.26 (as of last Friday). This P/E doesn’t have a 134-year history, but here is what Factset says about the forward P/E: “The current 12-month P/E ratio is stil below the 15-year average (16.0). During the first two years of this time frame (1999 – 2001), the forward P/E ratio was consistently above 20.0, peaking at around 25. With the forward P/E ratio still below the 15-year average and not close to the higher P/E ratios recorded in the early years of this period, one could argue that the index may still be undervalued.”

Is P/E Ratio Analysis Worthless?

There are two problems with P/E ratio based valuation analysis:

1) Corporations can and often do fudge their balance sheets (such as FASB rule 157). More details about one of the biggest loopholes here: The Simple Trick that Ruined the P/E Ratio for Everybody

2) Multiple expansion: Multiple expansion is a fancy term for investors’ willingness to overpay for stocks. Some research suggests that 70% of bull market returns are based on multiple expansion.

The ‘Non-Fudgeable’ Valuation Metric

Investors are irrational and corporations can cook the books, but one gauge that can’t be fudged are dividends. Dividends are either paid, or not.

The S&P 500 dividend yield was at 1.94% on December 31 (1.85% today).

The 134-year average is 4.32%. The highest yield was 13.84% (June 1932), the lowest yield 1.11% (August 2000).

Based on dividend yields, the S&P 500 is 57.2% overvalued.

Conclusion

As the chart comparison of the various valuation metric with the S&P 500 shows, valuations don’t work as short-term market timing tools. What does work as short-term timing tool?

Investor sentiment has been a very helpful tool. Extreme bearishness in May foreshadowed higher prices. This has now shifted, and two sentiment gauges have turned bullish, in fact they are at multi-year extremes. Here’s what this means for stocks:

Two Sentiment Gauges Reach Multi-Year Bullish Extremes

Simon Maierhofer is the publisher of the Profit Radar Report. The Profit Radar Report presents complex market analysis (S&P 500, Dow Jones, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE iSPYETF Newsletter to get actionable ETF trade ideas delivered for free.

The Simple Trick That Skewed the S&Ps P/E Ratio For Everyone

Investing is about value, buying low and selling high. But how do you determine value if the most popular value gauge has been compromised. Yes, via a 2008 economic stabilization act, Congress changed the ‘E’ of P/E.

In 2008 everyone (aside from short-sellers) were in crisis mode. Banks, Federal Reserve, Treasury Secretary and the President were ready to do whatever it takes to get the job done.

The job? Bail out banks and push the S&P 500 higher (SNP: ^GSPC). How? Didn’t matter.

The job got done, and with stocks as with sausages, if the end result tastes good you don’t ask how they’re made.

Not a day goes by where we don’t read about bank profits, bank bonuses, and bank shenanigans to make more profit. So let’s talk about bank profits for a moment.

Not everything that shines is gold and not everything that’s black on the income statement is profit.

From Mark-to-Market to Mark-to-Make-Believe

There was a time when banks loved the Mark-to-Market accounting model, because it allowed them to showcase truly miraculous real time profits. By 2006/07 the financial sector accounted for over 40% of S&P 500 earnings.

Things changed in 2007/08. Mark-to market wasn’t so popular with banks because it revealed enormous real time losses. Bankers don’t like to see red. Bankers prefer to hide their losses.

The Federal Reserve and Congress decided that’s a good idea since losses erode confidence.

Bankers lobbied the Financial Accounting Standards Board (FASB) to change the fair market accounting rule – rule 157 – but the FASB resisted. The FASB knew that changing fair market or Mark-to-Market was a free pass that practically required no write-downs ever.

However, via the Emergency Economy Stabilization Act of 2008, Congress gave the SEC the authority to suspend Mark-to Market accounting. FASB was strong-armed and FASB rule 157 was suspended on April 2, 2009.

FASB 157 – What Does it Mean?

Since April 2, 2009, banks are basically free to value their toxic assets as they please. This example illustrates how the financial engineering formula works in real life.

The two charts below show 1) S&P 500 P/E ratio and EPS (based on as reported data) 2) S&P 500 financial sector EPS (datasource: Standard & Poor’s).

Bank ABC holds mortgage-backed assets originally valued at $1,000. After running some proprietary and non-verifiable models the bank determines it will eventually sell the asset for $950. The loss, termed credit loss, is only $50.

However, because of MBS bad rep, the banks portfolio is currently worth only $500. The actual current value ($500) minus the credit loss ($50) is called noncredit loss ($450).

The $450 noncredit loss is recorded on the balance sheet under “comprehensive income,” but is not run through the income statement. Those losses don’t affect earnings, and are excluded from banks’ regulatory capital calculation.

That’s right, every single bank earnings report since April 2, 2009 did not account for losses from toxic assets.

This means that the P/E ratio for ETFs like the Financial Select Sector SPDR (NYSEArca: XLF) and by extension the SPDR S&P 500 ETF (NYSEArca: SPY) is skewed.

It’s been nearly four years since the FASB rule 157 change, so why write about it now?

Because the European Commission is proposing a similar accounting change, and (this is a real shocker) confiscation of private assets to help banks. More details here: Europe Proposes Mass Confiscation of Private Assets

Simon Maierhofer is the publisher of the Profit Radar Report. The Profit Radar Report presents complex market analysis (S&P 500, Dow Jones, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE iSPYETF Newsletter to get actionable ETF trade ideas delivered for free.

AMZN Slices Below Key Support – With P/E of 1,403 Downside Risk is Enormous

Investors buy Amazon for its founder’s vision and ingenuity, not because the company is a cash cow. The problem with a ‘vision based investment,’ and a four-digit P/E ratio is immense down side risk once momentum wanes.

Jeff Bezos, Amazon’s founder, is an incredible visionary.

Amazon.com Inc (Nasdaq:AMZN) operates on razor thin profit margins, so investors buying AMZN invest in Bezos’ vision, not a cash cow.

A look at AMZN’s chart (up until January 22) shows that Bezos’ vision trades at a premium. That premium made Amazon the fourth biggest component of the Nasdaq-100 and Nasdaq QQQ ETF (Nasdaq: QQQ).

Amazon also ranks #21 on the list of S&P 500 and SPDR S&P 500 ETF (NYSEArca: SPY) components.

The January 5 Profit Radar Report featured this little piece of financial trivia:

Which high-flying tech leader has a P/E ratio of 1,403? Tip: This stock is the fourth biggest component of the Nasdaq-100. Answer: Amazon (AMZN). Amazon founder Jeff Bezos is a true visionary and Amazon is working on amazing technology, but ultimately earnings are more important than pure vision.”

Featured along with the trivia was the first chart below and this warning:

Near-term support is around 380. A close below 380 would open the door for much lower targets.”

I’d like to point out that the Profit Radar Report doesn’t customarily feature single stock analysis (most analysis is based on the S&P 500), but every once in a while it looks at stocks too ‘bubbleicious’ to ignore.

Those stocks included Apple (September 12, 2012 Profit Radar Report) and Tesla (August 31, 2013 Profit Radar Report) and now Amazon (and one other high-flying stock).

The second chart zooms in on Amazon’s more recent performance.

AMZN gapped below 380 last Friday and lost as much as 15% since January 22.

Based on Amazon’s sky-high P/E ratio, the down side risk is quite enormous. The key level for Amazon shorts is 380.

The Profit Radar Report identified one other high-flying tech name that looks too ‘bubbleicious’ to ignore. Unlike AMZN, it still trades within a few percent of its all-time high. It also just reached its up side target and sports a lot of down side risk.

Sunday’s special edition of the Profit Radar Report profiled this short-term trade along with a longer-term forecast for the S&P 500 (PS: If you are thinking about signing up for the Profit Radar Report, keep in mind that it is not a stock picking service).

Simon Maierhofer is the publisher of the Profit Radar ReportThe Profit Radar Report presents complex market analysis (S&P 500, Dow Jones, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE iSPYETF Newsletter to get actionable ETF trade ideas delivered for free.

Are Corporate Earnings and P/E Ratios a Leading Stock Market Indicator?

As usual, Alcoa kicked off the quarterly earnings ritual. Corporate profits will be on display for weeks to come, but are earnings a leading or lagging indicator? Here’s the long-term effect of earnings on stocks and the one pattern worth watching right now.

‘Tis the season to get jolly about earnings. The quarterly earnings ritual pays a visit every quarter and captures the interest of Wall Street and Main Street alike.

How much do corporate earnings affect stocks? Are earnings a leading stock market indicator?

A chart says more than a thousand words and the one below plots the S&P 500 against US corporate profits measured in nominal dollars and corporate net profits as a percentage of GDP.

Fundamental analysts use earnings per share (EPS) and P/E ratios to figure out where a stock should be trading. By extension the same process is applied to broader indexes, like the S&P 500 or Dow Jones.

As evidenced by the chart, there has been an obvious correlation between profits and stock prices (at least since the late 1990s), but its not as snug as some analysts make it seem.

Corporate profits rolled over several quarters before the stock market peaked in 2000 and 2007. In hindsight, one might extrapolate that corporate profits are a leading indicator.

However, the problem is that profits aren’t known until well after the fact. Earnings are released after the fact and the Bureau of Economic Analysis (BEA) reports quarterly profits with a 3-month time lag.

In addition, who knows if a one-quarter decline is just a one-quarter chink in the chain leading to higher prices or the beginning of the next recession?

If you’re inclined to wait for a second quarter, you’re already talking about a 9-month time lag. The long-term earnings picture provides little direction for short-term investment decisions.

Here’s a short-term first quarter earnings pattern that’s worth watching. Solid earnings, even record earnings, have been followed by weak stock performance in April/May.

P/E Ratio Based Valuations are Beyond Deceptive

P/E ratio analysis used to be a time-tested, go to valuation parameter. Recent changes however, have turned the P/E ratio into the most deceptive value barometer around. Here’s why.

The P/E ratio is based on profits and only reliable as long as the “P” in P/E are actual profits. In a world where Wall Street thrives on manipulation, do P/E ratios still apply?

To illustrate: Wells Fargo is trading around $33 a share with earnings per share of $3.18 and a P/E ratio of 10.40. This is cheap, isn’t it?

But how do we know that Wells Fargo’s profit is really $3.18 a share?

As of December 30, 2011, Wells Fargo had total assets of $1.313 trillion and total liabilities of $1.173 trillion. You and I don’t know what the assets and liabilities are, and I venture to say that Wells Fargo doesn’t even know.

How much are the millions of homes Wells Fargo financed before the housing bust really worth? Again, we don’t know, but we know that due to an FASB (Financial Accounting Standard Board) rule change, Wells Fargo and every other corporation in the U.S. can now overstate the value of their under water assets.

FASB Rule 157

FASB rule 157 applies to fair value (or mark-to-market) accounting. Fair value is (or used to be) defined as “the price that would be received to sell an asset or paid to transfer liability in an orderly transaction between market participants.”

In 2008 the market turned disorderly and on April 9, 2009, the FASB (strong armed by Congress) changed rule 157 to suspend the fair value rules when the market is unsteady.

Instead of reporting the current value of an asset (market-to-market), corporations are now allowed to pick a price they believe the asset will be worth in the future (mark-to-make-believe).

Cause and Effect

What effect would this have? A March 2009 Bloomberg published this assessment:

“By letting banks use internal models instead of market prices and allowing them to take into account the cash flow of securities, FASB’s change could boost bank industry earnings by 20 percent. Companies weighed down by mortgage-backed securities, such as New York-based Citigroup, could cut their losses by 50 percent to 70 percent, said Richard Dietrich, an accounting professor at Ohio State University in Columbus. ‘This could turn net losses into significant net gains,” Dietrich said.’”

Is that really what happened? Let’s see which companies drove earnings growth for the S&P 500 in 2012.

The chart and data below was compiled by Morgan Stanley’s Adam Parker. According to his research, ten stocks are driving about 88% of the entire S&P 500 earnings growth.

Six (seven if you consider GE a financial stock) of the ten companies belong to the financial sector (Bank of America, AIG, Goldman Sachs, Wells Fargo, JPMorgan Chase, Citigroup).

Without Apple and the financial sector, earnings growth for the S&P 500 would be next to zero. A bad year for Apple and a return to fair value accounting could easily double the P/E ratio.

Based on P/E ratios, does the S&P 500 still look cheap?

Simon Maierhofer shares his market analysis and points out high probability, low risk buy/sell recommendations via the Profit Radar Report. Click here for a free trial to Simon’s Profit Radar Report.

The S&P 500 is Overvalued Based on P/E Ratio

Do valuations matter in today’s market? Just as you look at a Blue Book before buying a car, you should look at valuations before buying a stock. Even though it doesn’t mean stocks are ready to decline right now, P/E ratios suggest stocks are priced for long-term pain.

Are stocks overvalued? That’s a good question, but a better question is whether stocks are priced for long-term gains?

An individual stock – or the entire stock market – can be overvalued and still increase in value. A drunk driver may still be able to operate a vehicle, but the odds of a drunk driver or overvalued market to crash is much higher.

Buying an undervalued stock (or staying out of an overvalued market) on the other hand, places the odds in favor of the investor.

When dealing with probabilities – which is what investing is all about – having the odds in your favor is the best you can do.

Having that in mind, we ask again: Are stocks set to delivery long-term gain or pain?

Before we get to the valuation analysis, keep in mind that valuations are a long-term guide. We don’t use long-term indicators for short-term trades. A number of shorter-term indicators point to still higher prices ahead.

Pain or Gain?

Today we’ll look at valuations based on P/E ratios.

The current P/E ratio (based on Robert Shiller’s cyclically adjusted P/E ratio) is 21. The average P/E ratio going back to the year 1900 is 16.9. In other words, the P/E ratio is 26.9% above its historic average.

A reversion to the mean would imply a 26.9% drop in stock prices or a dramatic increase in earnings.

Is there a correlation between P/E ratios and the S&P 500? The chart below plots P/E ratios against the S&P 500. The vertical red and green lines highlight the correlation between P/E ratios and market tops/bottoms for the S&P 500.

Current P/E ratios are not at extremes that have historically marked major tops or bottoms, but P/E ratios do at best suggest sluggish growth going forward.

The visually illustrated study below shows the correlation between P/E ratios and their respective forward return.  The study covered the period from 1871 – 2010 and is based on the S&P 500 (S&P predecessors prior to 1957). P/E ratios are based on rolling average ten-year earnings/yields.

P/E ratios and the corresponding ten-year forward returns, were grouped into five quintiles in 20% intervals. As the chart shows, the cheapest quintile had the highest ten-year forward return while the most expensive quintile had the lowest return.

The projected 10-year forward real return for the S&P 500 (and SPY ETF) with a P/E ratio of 21 stocks is around 4.5%.

Keep in mind that the 1871 – 2010 span hosted multi-decade bull markets where P/E ratios remained in overvalued territory for extended periods of time. During a bear market, the forward return is likely to be much lower than the study suggests.

There are other factors that influence earnings, P/E ratios, and ultimately stocks’ performance. Those factors will be the subject of an upcoming article.

Simon Maierhofer shares his market analysis and points out high probability, low risk buy/sell recommendations via the Profit Radar Report. Click here for a free trial to Simon’s Profit Radar Report.

Are Stocks Overvalued? Yes, According to Dividend Yields

In a world of iPhones, social media, and twitter, it’s easy to forget about time proven market forecasting techniques. But just because there isn’t an app for dividend-based value analysis doesn’t mean it’s not working anymore.

Nobody likes to get trapped. Animals don’t like traps, humans don’t like traps, and investors hate money traps. But how do you distinguish a profit opportunity from a profit trap?

From October 2011 to September 2012 the S&P 500 gained 37%. Was this the beginning of a new bull market or the final leg of the QE bull market?

From March 2009 to September 2012 the S&P 500 soared 121%. Is this rally a new bull market leading to new all-time highs or a monster counter trend rally?

Charles Dow, the founder of the Wall Street Journal and original author of the Dow Theory, said that: “To know values is to know the market.” Yes, valuations might well hold the key to the above questions.

I follow four metrics to determine fair value:

1) Dividend yields
2) P/E ratios
3) The Gold Dow
4) Mutual fund cash levels

A special report analyzing all four valuation metrics was sent out to Profit Radar Report subscribers on Thursday. This article will look at one metric: Dividend yield.

What Dividend Yields Teach about Value

What connection is there between fair value and dividend yields? To illustrate:

Company A trades at $100 a share and pays a dividend of $5 per share. Company A’s dividend yield is 5%.  If company A’s shares soared to $200 a share without dividend increase, the yield will fall to 2.5%.

There’s a direct correlation between a company’s share price and its dividend yield. Higher stock prices lead to lower yields. Low dividend yields are a result of pricey stocks.

Dividend yields are probably the purest measure of valuations. Unlike P/E ratios, they can’t be fudged and massaged (although the current dividend yield is likely inflated by the Fed’s low interest rate policy, which makes it easier for companies to accumulate the cash needed to pay dividends).

Since the year 1900 dividend yields for the S&P 500 have averaged 4.25%. The SPDR S&P 500 ETF (SPY) currently yields 2.02%, 52.5% below the historic average.

The current yield is much closer to the all-time low of 1.11% (August 2000) than the all-time high of 13.84% (June 1932).

The chart below juxtaposes the S&P 500 (log scale) against dividend yields and shows that every major market top coincided with a yield low, and every major market low coincided with a yield high.

Dividend yields aren’t currently at an extreme that requires an immediate drop in stocks, but they do suggest that stocks are overvalued.

What Does this Mean?

What do low yields mean for investors? Valuation metrics are long-term forecasting tools, they shouldn’t be used to enter or rationalize short-term trades.

The long-term message of dividend yields is that the down side risk is greater than the up side potential. The next big move will likely be on the down side.

The best entry point for long-term trades is usually discovered by shorter-term market timing tools. Every prolonged decline starts on the hourly and daily chart.

The Profit Radar Report monitors long-and short-term market timing indicators to identify low-risk high probability trading opportunities.

Simon Maierhofer shares his market analysis and points out high probability, low risk buy/sell recommendations via the Profit Radar Report. Click here for a free trial to Simon’s Profit Radar Report.