The Market Is Now Between 33% And 51% Overvalued

Here is a summary of the four market valuation indicators I updated at the beginning of the month.

● 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 price 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 per cent 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 33 per cent to 51 per cent, depending on the indicator. This is an increase over the previous month’s 31 per cent to 48 per cent range.

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.

Click to enlarge

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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 43 per cent to 61 per cent, an increase over last month’s 41 per cent to 57 per cent.

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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 many years. But they can play a role in framing longer-term expectations of investment returns. At present market overvaluation continues to suggest a cautious long-term outlook and guarded expectations. However, at the today’s low annualized inflation rate and the extremely weak return on fixed income investments (Treasuries, CDs, etc.) the appeal of equities, despite overvaluation risk, is is not surprising.

 

Note: For readers unfamiliar with the S&P Composite index, see this article for some background information.

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