Is the stock market overvalued?

Discussion from AD 717 Investment Analysis and Portfolio Management at Boston University

Many equity indices tumbled by as much as 2% last Friday, and last week the stock market suffered its largest drop since September 2011 (WSJ).  However, it would be quite the stretch to label the market down considering the S&P 500 closed in the low 1500s this time last year – the S&P 500 price at the time of this post is 1792 (Google Finance).

Many investors and economists debate that the market is overvalued. Why? Consider the following valuation ratios of the S&P 500 (MarketWatch):

The S&P 500’s price/book ratio, used to compare a stock’s value to its book value, is currently 2.7 (PB Investopedia).  The price/book is higher than all but 5 of the 28 bull market tops since the 1920s (MarketWatch).  The price/sales ratio, which is calculated by dividing stock price by per-share sales, is currently 1.6, higher than all but 2 of the bull market tops since 1955 (MarketWatch). The S&P 500’s dividend yield, which is a percentage of a company’s stock price that is represented by total annual dividends and tends to fall as prices stock prices rise, is currently 2%.  This is lower than all but 5 of the bull market tops since 1900 (MarketWatch). The Shiller P/E ratio, calculated by dividing a company’s stock price by inflation-adjusted earnings in the last 10 years, is 25.6, higher than 29 of the 35 tops since 1900 (MarketWatch).  Lastly, the the S&P 500’s P/E ratio, which is calculate by dividing stock price earnings by share, is 18.6.  This is higher than 24 of the 35 bull market tops since 1900.

The current price and ratios of the S&P 500 proposes that the market is indeed expensive. However, Federal Reserve policies have created a vast amount of confusion and speculation in the valuation of our current market. Only time - and perhaps economic policy changes in the future - will tell if the market is truly overvalued.

As for Shiller PE (CAPE) v. PE, it is tough to narrow it to just one.  Like all financial ratios, it truly depends on the investor’s personal goals and beliefs.  On one hand, the Shiller PE will include holes and distortions in a period – and we can all agree that the past decade has been anything but normal (NYTimes). On the other, a PE ratio may be inaccurate if it is following a period of peak earnings. Furthermore, firms that have recently sold off a piece of their business or received a big one-time gain from the sale of a division can ‘artificially’ inflate their earnings. Based on their operating earnings the stock may not be cheap at all (Morningstar).

Both P/E ratios are very powerful tools in investment analysis; however, if an investor does not use them side by side with other valuation rations, they are essentially useless.  An investor should use CAPE and P/E ratios in unison with other investment valuation rations, to include Price/Book, Price/Cash Flow, Price/Earnings to Growth, and Price/Sales ratios.

Food for thought: based on our active/passive discussion last week, how successful do you think the above mentioned ratios have been in predicting stock prices?

Josh

Sources:

(WSJ) http://online.wsj.com/news/articles/SB1000142405270230
(PB Investopedia) http://www.investopedia.com/terms/p/price-to-bookratio.asp
(MarketWatch) http://www.marketwatch.com/story/six-ratios
(NYTimes) http://www.nytimes.com/2012/10/14/your-money/debating-cape
(Morningstar) http://news.morningstar.com/classroom2/course.asp?docId=145100&page=6&CN=