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.

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Are Stocks Cheap or Overpriced? Here’s Why Analysts Passionately Disagree

Stock market valuation is one of the most passionately fought arguments on Wall Street: Are stocks cheap or expensive? They can’t be both. Here’s why analysts are disagreeing, and why their valuations may not matter anyway.

A standard is defined as a rule set by an authority to measure quantity, quality, weight or value. In short, standards are established to limit confusion.

By what standard are analysts measuring stock market valuation?

There must be different ‘standards,’ because stock market valuation is a passionately fought and never-ending debate.

Some analysts say that stocks are overvalued, others argue they are cheap. How can that be and who is right?

This article will review three different valuation metrics, each plotted against the S&P 500 (time frame: from 1881 – 2013; datasource: Robert Shiller) and two variables that make P/E analysis almost worthless.

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 (18.91 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 is 19.6% 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 (25.62 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 and S&P 500 ETF is 54.24% overvalued.

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.

To wit. In January one high-flying tech stock was trading with a P/E ratio of 1,403. The January 5 Profit Radar Report featured this little tidbit:

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. A close below 380 would open the door for much lower targets.”

From January to May AMZN lost as much as 30%. Willingness for ‘multiple expansion’ creates bubbles, and there’s no telling when bubbles start or end. It’s a wild card. Ultimately a stock is worth as much as investors are willing to pay for it, regardless of its P/E ratio.

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 (1.91% 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 55.79% overvalued.

Conclusion

Each of the above charts are plotted against the S&P 500, providing a clear visual that valuations don’t work as short-term market timing tools. What does work as short-term timing tool?

Here is a closer look at a fascinating type of analysis that’s pegged the recent S&P 500 moves:

S&P 500 Analaysis: The Chopping Zone Explained

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.

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.