Is The Stock Market Overvalued?

Updated on
Stock market Valuation

Every day as the market sets new highs for the year, many pundits are commenting that the market is getting over valued. The pundits will cite current data, which shows that the P/E of the stock market is extremely high. Respected people including Bill Gross of PIMCO and Noureil Roubini are on TV on an almost daily basis proclaiming the market is over valued and about to have a large decline. Many of these pundits were also calling in early February of this year, for the Dow Jones to drop to 5,000 or even 3,000. Many of them who made wrong predictions then are confident enough to continue with their market timing forecasts.

I do not think anyone can accurately predict the short term movements of the stock market. Leaving that point aside lets assume like these “experts” that if the market is over valued it can be accurately predicted that it will decline soon. However, I do think it is accurate to call the market over valued due to current low earnings. The P/E is very high due to the worst earnings decline in history. It is not accurate to call the market over valued based on the past 12 months which by any standard was abnormal. If current P/E data is distorted, how then can it be ascertained what the current market valuation should be? I looked at six different metrics of market valuation to try to answer this question.

P/E TTM

On a TTM basis the S&P has a P/E of 87. (Current S&P value 1106 divided by last 12 months earnings of 12.72). Based on this data the market is significantly overvalued. 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.

P/E 10 Year Average

The 10 year P/E ratio is currently 20.05. This number is based on Rober Shiller’s data evaluating The average inflation-adjusted earnings from the previous 10 years. This is slightly over valued since the average P/E is around 15. However with interest rates at zero, the market should be trading at a slightly higher P/E than the historical norm. The market with an earning yield of about 5% looks much more attractive than 10 year treasury yields of 3.5%.

P/BV

The average Price over book value of the S&P over the past 30 years has been 2.4. Today, that number is about 2.33, showing the market is slightly under bought. 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.

Dividend Yield

The current dividend yield of the S&P is 2.29. T It is hard to determine on this basis whether the market is over priced. 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 over priced 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 over bought based on the low dividend yield.

Stock Market Capitalization as perccentage of GDP

Stock Market Capitalization as a percentage of GDP is another metric albeit less commonly used than other metrics, to value the market. The total stock market index has a current capitalization of about $11.34 trillion. This is 79% of GDP which is $14.2 trillion, this is close to the historical average. Between 75-90% market capitalization as percentage of GDP is a fair value, therefore at a current level of 79%, the stock market is fairly valued. Warren Buffett stated that market capitalization as a percentage of GDP is “probably the best single measure of where valuations stand at any given moment.”

Tobins Q

Another value of stock market valuation which is less commonly used than many of the above methods are the Tobins Q. Tobins Q is currently about .86. This would show that the market is slightly over valued. The Tobins Q’s average over several decades of data about .72. In the past Tobin’s Q has been a good indicator of future market movements. In 1920 the number was at a low of .33, the next nine years included phenomenal gains for the market. In 2000 Tobin’s Q almost reached a record high of nearly 2, and the market declined subsequently about 50% by 2003.

To recap
1. P/E(TTM)- Extremely overvalued
2. P/E(10 year average)- slightly over valued
3. P/BV- Slightly Under valued
4. Divdend Yield- Indeterminate/ Fairly valued
5. Market value relative to GDP- fairly valued
6. Tobins Q-Slightly Over valued

In conclusion the market is definitely not extremely over valued based on the above data. However, the case can be made that stocks may be slightly over valued based. However the historical data fails to take into account current record low interest rates. Taking into account interest rates, the market seems to be fairly valued currently.

disclosure: none

Leave a Comment