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.

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Apple Becomes Second Most Valuable Brand in the World, But Traders Get Scared

Apple is the most valuable company in the world. Now it is also the second most valuable brand in the world. Nevertheless, traders are concerned about Apple stocks which is reflected in the price of options.

According to brand consultancy firm Interbrand, Apple’s brand value increased 129% to $76.57 billion last year. This makes Apple the new #2 on Interbrand’s list of the top 100 brands.

Apple is followed by IBM ($75.53 b), Google ($69.72 b) and Microsoft ($57.85 b). #1 and the only non-tech company in the top 5 is Coca Cola with a brand value of $77.83 billion. The chart below shows the top 28 brands.

Apple’s growth outpaced even Google’s steep growth trajectory. Apple and Google surpassed Microsoft for the first time ever.

Interbrand’s key valuation aspects are the financial performance of the branded products or services, the role of the band in the purchase decision process and the strength of the brand.

Traders Become Skeptic

As of recent Apple has hit some speed bumps. It didn’t sell as many iPhones as expected and basically had to admit that Apple maps is inferior to Google maps.

More importantly, Apple’s stock (AAPL) became too overbought. Even before the iPhone went live and Apple maps draw criticism, the September 12 Profit Radar Report recommended to: “Short Apple (or buy puts or sell calls) above 700.”

With Apple trading about $35 below its all-time high, option traders have become unusual bearish. Bloomberg reports that bearish Apple options are the most expensive relative to bullish options since late 2011. This seems like an overreaction considering a moderate drop of only 5%.

Newsletter writers that cover major stock market indexes like the S&P 500 saw a similar sentiment movement. The percentage of bullish advisors polled by Investors Intelligence dropped from 54.20% on September 18 to 46.80% on October 2. The SPDR S&P 500 ETF (SPY) lost less than 2% during that time.

The S&P 500 continues to trade within a parallel trend channel and support for Apple is at 660, 650 and around 635. It seems that the immediate down side for stocks and Apple is limited.

Bi-Polar Technology Sector is Torn By Performance of Groupon, Facebook and Apple

About 18 months ago stocks were fueled by the Facebook, Groupon, and the smart phone app frenzy (i.e. Angry Birds). None of the above companies are actually included in the Technology Select Sector SPDR ETF, but the prospect of a new tech boom was enough to lift the entire sector.

And while the technology sector has continued to move higher, it has left Facebook, Groupon and others in the dust. Why? Allow me to republish some research notes previously reserved for subscribers.

Facebook Warning: Published May 11, 2012

“Facebook (FB) is expected to go public on Friday, May 19. The media will gladly spread the frenzy, but I’d like to point out a few nuggets to put Facebook’s insane valuation into perspective:

– Assuming a valuation of $100B, FB will trade at 33x advertising revenues. Google trades at 5.5x.

– At $100B, FB will be worth more than: Caterpillar, American Express, Home Depot, Walt Disney and even McDonalds. In fact, 15 components of the mighty Dow Jones Industrial Average have a market cap of less than $100B.

– The market value of Google at its IPO was “only” $27B

– Apple currently trades around 3.8x sales. The same metric applied to FB would put its valuation at $15B.

To some degree the social media bubble is reminiscent to the 1999 tech boom. Most social media companies are valued based on promises more than established accounting standards. Recent IPO’s of Groupon, Pandora, Yelp, and Zynga created a lot of hope during the first couple of days of the IPO and fizzled thereafter.

Will FB await the same fate? You can’t predict the extent of any frenzy, but the amount of fizzled frenzies dwarfs that of sustainable ones. My bold prediction is that FB will loose at least 30% of its IPO price by sometime in 2013.”

Well, it turns out I was wrong. Since its May 2012 IPO ,Facebook shares have fallen as much as 61% (from a high of $45 to a low of $17.55). Facebook’s market cap is now $44 billion.

Groupon Warning: Published December 17, 2010

It was my belief that the Groupon movement (group coupons) is dangerous for the economy and unsustainable. This was contrary the most of Wall Street‘s outlook. I picked on James Altucher, a popular tech cheerleader, to contrast our difference of opinions.

“Altucher doesn’t believe there’s a new social media/coupon bubble. This time is different because Groupon’s rejection of Google’s $6 billion bid is ‘the dawn of a new and improved internet bubble. Unlike the bubble of the late 90s, though, this one is based on fundamentals, not irrational exuberance’.

It’s ironic that Groupon’s success and refusal of Google’s advance is seen as the dawn of a new era. Groupon has a killer business model, which is a goldmine for Groupon, but poison for healthy economic growth.

This new way of buying nurtures frugality and robs restaurants and other retail stores of their pricing power. Groupon is feasting on a deflationary trend while wizards like Altucher see the company as a gateway to the new and improved economy.

According to Altucher this is ‘not a bubble, it’s a real significant boom.’ It’s a boom all right, we’ll just have to see whether it’s an economic or deflationary boom. My money is on the later.”

Since its November 2011 IPO Groupon shares have fallen from a high of $31.14 to a low of $4. Groupon’s current market cap is $3 billion, half of what Google was willing to pay for the company.

Technology Sector at 11+ Year High. Why?

The Facebook, Groupon, smart phone app boom is deflated, so why has the tech sector moved on to an 11+ year high?

A look at the top holdings of the Technology Select Sector SPDR ETF (XLK) may hold the answer.

Apple, IBM, and Google account for 34% of XLK and trade at or near all-time highs.

Microsoft, AT&T, and Verizon account for 19% of XLK and, like the Nasdaq-100, trade at or near a 10-year high.

Former highflyers like Cisco, EMC, Hewlett Packard, Corning, Yahoo, Broadcom, Dell, Applied Materials, Sandisk, Juniper Networks and others continue to trade near the lower end of their 15-year range.

It appears that a few strong companies mask the performance of many weak companies. That’s not the definition of a strong market or sector.

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.