Data Suggests Market Overvalued from 22% to 54%

Here is a summary of the four market valuation indicators :

● 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've adjusted the two P/E ratios and Q Ratio to their arithmetic means and the inflation-adjusted S&P Composite to its exponential regression. Thus 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. Based on the latest S&P 500 monthly data, the market is overvalued somewhere in the range of 22% to 42%, depending on the indicator.

Given the 10.77% monthly gain in the S&P 500 in October, it should come as no surprise that all of the indicators are showing increased overvaluation from last month's numbers. However, as I pointed out in my separate Q commentary, the Flow of Funds data on which the Q Ratio based is increasingly stale. The new Flow of Funds report will be released on December 8th, at which time I'll post a Q update.

I've plotted the S&P regression data as an area chart type rather than a line to make the comparisons a bit easier to read. It also 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.

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The chart below 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"). 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. In this chart the range of overvaluation would be in the range of 31% to 54%.

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As I've frequently pointed out, these 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 continue to suggest a cautious long-term outlook and guarded expectations.

Source: Advisor Perspectives