I update market valuations on a monthly basis. The point of this article is to measure the stock market based on six different metrics. This article does not look at the macro picture and try to predict where the economy is headed. It only uses these six metrics which have been very good past indicators of whether the market is fairly valued. However, regardless of market valuations, there are always individual stocks that are undervalued.

I collaborate with my colleague Doug Short for some of the data in the article. Doug is an expert on market valuations, and I encourage readers to visit his site dshort.com

As always, I must mention that just because the market is over or undervalued does not mean that future returns will be high or low. From the mid to late 1990s the market was extremely overvalued and equities kept increasing year after year. However, as I note at the end of the article I expect low returns over the next ten years based on current valuations.

To see my previous market valuation article from last month click here.

Below are six different market valuation metrics as of October 4th, 2010:

The current P/E TTM is 16.1, which is higher than the TTM P/E of 15.8 from last month.

s&p 500 shiller p/e
Click to View

This data comes from my colleague Doug Short of dshort.com.

Based on this data the market is fairly valued. However I do not think this is a fair way of valuing the market when considering the significant decrease in earnings over the past year. To get an accurate picture of whether the market is fair valued based on P/E ratio it is more accurate to take several years of earnings.

Numbers from Previous Market lows:

Mar 2009 110.37

Mar 2003 27.92

Oct 1990 14.21

Nov 1987 14.45

Aug 1982 7.97

Oct 1974 7.68

Oct 1966 13.96

Oct 1957 12.67

Jun 1949 5.82

Apr 1942 7.69

Mar 1938 10.63

Feb 1933 14.92

July 1932 10.16

Aug 1921 14.02

Dec 1917 5.31

Oct 1914 14.27

Nov 1907 9.35

Nov 1903 11.67

Historic data courtesy of [www.multpl.com]

Current P/E 10 Year Average 20.75

S&P 500 P/E Ratio Chart  - Linear Scale
The current ten year P/E is 20.75; this is higher than the PE of 20.05 from the previous month. This number is based on Robert Shiller’s data evaluating the average inflation-adjusted earnings from the previous 10 years. Based on my colleague, Rob Bennett’s market return calculator, the returns of the market should be as follows:

Stock Market Best Possible Lucky Most Likely Unlucky Worst Possible
10-Year Percentage Returns 8.78 5.78 2.78 -0.22 -3.22
20-Year Percentage Returns 7.77 5.77 3.77 1.77 -0.23
30-Year Percentage Returns 8.41 7.41 6.41 5.41 4.41
40-Year Percentage Returns 7.30 6.40 5.50 4.50 3.50
50-Year Percentage Returns 7.30 6.50 5.70 5.00 4.30
60-Year Percentage Returns 7.67 7.02 6.37 5.77 5.17

My colleague Doug Short thinks this numbers are a bit inaccurate, because the number I used as it does not include the past several months of earnings, nor revisions. Doug calculates P/E 10 at 20.5.

Click to View

Mean: 16.37

Median: 15.76

Min: 4.78 (Dec 1920)

Max: 44.20 (Dec 1999)

Numbers from Previous Market lows:

Mar 2009 13.32

Mar 2003 21.32

Oct 1990 14.82

Nov1987 13.59

Aug 1982 6.64

Oct 1974 8.29

Oct 1966 18.83

Oct 1957 14.15

June 1949 9.07

April 1942 8.54

Mar 1938 12.38

Feb 1933 7.83

July 1932 5.84

Aug 1921 5.16

Dec 1917 6.41

Oct 1914 10.61

Nov 1907 10.59

Nov 1903 16.04

Data and chart courtesy of [www.multpl.com]

This is moderately over valued from the average P/E as shown above.

Current P/BV 2.25

???price over book s&p 500 chart

This is a very rough estimate, it is nearly impossible to get an exact number for P/B on a specific date to my knowledge.

The current P/BV is 2.25; this is above P/B of 2.09 I measured in my previous article.

The average Price over book value of the S&P over the past 30 years has been 2.41. This indicates the market is undervalued. Book value is considered a better measure of valuation than earnings by many investors including legendary investor Martin Whitman. He states that book value is harder to fudge than earnings. In addition book value is less affected by economic cycles than one year earnings are. P/BV therefore provides a longer term accurate picture of a company’s value, than a TTM P/E.

Current Dividend Yield 1.94

S&P 500 Dividend Yield Chart  - Linear Scale

The current dividend yield of the S&P is 1.94. This number is lower than the 2.04% yield from last month.

It is hard to determine on this basis whether the market is overpriced. The dividend yield for stocks was much higher in the begging of this century than the later half. The dividend yield on the S&P fell below the yield on Ten-Year treasuries for the first time in 1958. Many analysts at the time argued that the market was overpriced and the dividend yield should be higher than bond yields to compensate for stock market risk. For the next 50 years the dividend yield remained below the treasury yield and the market rallied significantly. In addition the dividend yield has been below 3% since the early 1990s. While I personally favor individual stocks with high dividend yields, I must admit that the current tax code makes it far favorable for companies to retain earnings than to pay out dividends. Finally, as I noted above the current economic environment has zero percent interest rates and low bond yields. During periods where yields are low it is logical for income oriented investors hungry for yield to be bid up the market, and dividend yields to decrease. I think it is hard to claim the market is overbought based on the low dividend yield.

Mean: 4.36%

Median: 4.29%

Min: 1.11% (Aug 2000)

Max: 13.84% (Jun 1932)

Numbers from Previous Market lows:

Mar 2009 3.60

Mar 2003 1.92

Oct 1990 3.88

Nov1987 3.58

Aug 1982 6.24

Oct 1974 5.17

Oct 1966 3.73

Oct 1957 4.29

Jun 1949 7.30

Apr 1942 8.67

Mar 1938 7.57

Feb 1933 7.84

July 1932 12.57

Aug 1921 7.44

Dec 1917 10.15

Oct 1914 5.60

Nov 1907 7.04

Nov 1903 5.57

Data and chart courtesy of [www.multpl.com]

Ratio = Total Market Cap / GDP Valuation
Ratio < 50% Significantly Undervalued
50% < Ratio < 75% Modestly Undervalued
75% < Ratio < 90% Fair Valued
90% < Ratio < 115% Modestly Overvalued
Ratio > 115% Significantly Overvalued
Where are we today (10/04/2010)? Ratio = 82.2%Fairly rvalued

The current level of  82.2%, is higher than the 74.9% number recorded from last month.

Stock Market Capitalization as a percentage of GDP is another metric albeit less commonly used than other metrics, to value the market. Between 75-90% market capitalization as percentage of GDP is considered fairly valued. Based on Guru Focus data the market should return about 6.2% per year based on the current value.

Warren Buffett has stated that market capitalization as a percentage of GNP is “probably the best single measure of where valuations stand at any given moment.”

According to Barron’s the ratio got as low as 40% in the

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