Must-know: Are market valuations stretched?

Market Realist

Must-know: Is the bubble bursting? (Part 2 of 3)

(Continued from Part 1)

That said, valuations certainly have started to become an issue, particularly for certain segments of the market.

For instance, at more than 25x current earnings estimates, valuations for small caps (IWM) look outright expensive. And particular pockets of the market – like last year’s growth stocks–are verging, or have already tipped into, bubble territory. The average price-to-book ratio for the Nasdaq Biotechnology Index is more than 7. As for Internet stocks, we are back to a world reminiscent of the late 1990s, where only the most creative metrics can justify the premiums being paid for certain companies.

Market Realist – The NASDAQ Biotechnology Index (IBB) is up 14% this year. Less than a third of its 122 companies earned any money in the last 12 months. The following graph shows the enormous price increase exhibited by the iShares NASDAQ Biotechnology Index Fund. Although the fund has experienced some correction since March, it still seems to be over-valued.

Does all this suggest that the market has peaked and stocks are likely to come crashing down? Not necessarily. It’s important to note that not all stocks look expensive. In the United States, the energy, healthcare, and surprisingly technology (not every tech stock is trading like Facebook) sectors are all trading comfortably below their historic valuations. Outside of the United States, stocks in Europe, Japan (EWJ), and most of developed Asia range from reasonably priced to cheap.

Market Realist – The valuation metrics of the S&P 500 (IVV), although high, are currently near historical average levels. On May 20, 2014, the price-earnings (or P/E) level of the market was 17.31. The trailing P/E ratio was nearly two points above its historical average. Over the last 25 years, the S&P 500′s average P/E ratio of 18.90 was more than 1.5 points above valuation. However, compared to the last decade, the P/E ratio for the S&P 500 (SPY) is modestly above the average of 16.95.

In addition, while the market is certainly vulnerable to a spike in interest rates or an economy slowing more than expected, I don’t expect these scenarios to occur. Rather, given my expectations of modestly accelerating economic growth and continued low rates in 2014, I still believe that the U.S. market will push ahead this year.

Market Realist — Read on to find out what how investors should shift strategies in the current scenario.

Continue to Part 3

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