These Indicators Suggest S&P 500 Overvalued In Excess of 40%!

4 Market Valuation Indicators Suggest S&P 500 Overvalued 34% to 61%!

The S&P 500 is considerably overvalued - somewhere in the range of 34% to 61% – depending on which of 4 market valuation indicators are used and whether the valuation is based on the arithmetric or geometric mean of each. While these findings are not useful as short-term signals of market direction…they play a role in framing longer-term expectations of investment returns and suggest a cautious outlook and guarded expectations. [Here are the details.] Words: 676

So says Doug Short (www.dshort.com) in excerpts from an article* which Lorimer Wilson, editor ofwww.munKNEE.com (It’s all about Money!), has further edited ([ ]), abridged (…) and reformatted below for the sake of clarity and brevity to ensure a fast and easy read. Please note that this paragraph must be included in any article re-posting to avoid copyright infringement. Short goes on to say:

The 4 market valuation indicators I follow and are used in this analysis are:

• The Crestmont Research P/E Ratio (more)
• The cyclical P/E ratio using the trailing 10-year earnings as the divisor (more)
• The Q Ratio, which is the total price of the market divided by its replacement cost (more)
• The relationship of the S&P Composite to a regression trendline (more)

[To facilitate comparisons I have plotted each market valuation indicator on the graph below to show the trend of each and the consistency, or lack thereof, of one to the other going back to 1900.] I have adjusted the two P/E ratios and Q Ratio to their arithmetic means and the inflation-adjusted S&P Composite to its exponential regression. As such, the percentages on the vertical axis show the over/undervaluation as a percent above mean value, which I’m using as a surrogate for fair value. I have also plotted the S&P regression data as an area chart type rather than a line to make the comparisons a bit easier to read which reinforces the difference between the line charts — which are simple ratios — and the regression series, which measures the distance from an exponential regression on a log chart.

The chart below – which differs from the one above in that the two valuation ratios (P/E and Q) are adjusted to their geometric mean rather than their arithmetic mean (which is what most people think of as the “average”) – shows the range of overvaluation of the S&P 500 somewhere in the range of 40% to 61%. The geometric mean weights the central tendency of a series of numbers, thus calling attention to outliers.

In my view, the first chart does a satisfactory job of illustrating these four approaches to market valuation, but I’ve included the geometric variant as an interesting alternative view for the two P/Es and Q ratio.

Conclusion

The above indicators aren’t useful as short-term signals of market direction – periods of over and under valuation can last for years – but they can play a role in framing longer-term expectations of investment returns. At present they suggest a cautious long-term outlook and guarded expectations.