How do you gauge the true worth of a market like the S&P 500? Like individual stocks, the price paid for the market as a whole may be higher or lower than its actual value, and market valuation matters.
To maximize investment gains, you don't want to overpay for stocks, whether it's an individual company or an entire market index. A significantly overvalued stock market might even prompt you to take action, perhaps by selling some stocks and shifting more of your assets into cash or bonds.
But there are many ways to value the stock market, and we describe eight of them here, including how they currently compare with historical markets. All but one of these market metrics are broadcasting the same message now: The market is overvalued.
Is that a reason to sell? Not necessarily, says Ben Carlson, director of institutional asset management at Ritholtz Wealth Management in New York. We've seen bear markets approximately every five years during the past 70-plus years, and valuations were elevated in many but not all the preceding periods, he says. Because predicting the exact peaks and valleys of a market is impossible, market valuations are merely a guide to future returns, not a crystal ball.
Price-earnings ratio. You can't value the market without considering how much the underlying companies in the index are really worth. The market valuation gold standard is the P/E ratio, also known as the trailing P/E ratio. It is the average share price of the firms in the S&P 500 divided by their average earnings per share for the preceding 12 months. The standard or trailing P/E currently equals 25, which is significantly higher than the historical mean of 16.
[See: 7 Historic Bear Markets.]
Forward P/E. Variations of the P/E ratio use different periods for earnings. For instance, the forward P/E ratio is similar to the trailing ratio except that the index's current average price is divided by the average earnings expected from all S&P 500 companies for the next 12 months.
Many investors prefer the forward P/E ratio to the standard P/E because they're more interested in where the market is headed rather than where it's been. Predictions for future earnings can be wrong, however, making this ratio less reliable. The forward P/E is now 17.29, slightly above the historical average of 17.2, indicating a slightly overvalued market.
Shiller P/E 10 or CAPE. With the Shiller P/E 10 or cyclically adjusted price-earnings ratio (CAPE), annual S&P 500 earnings for the past 10 years are adjusted for inflation and then averaged. The average current price for the index is divided by inflation-adjusted earnings. The CAPE is a popular metric because it smooths out corporate profits that usually ebb and flow during a business cycle.
Currently, the Shiller P/E ratio is 32.4, which is 91.7 percent higher than the historical mean of 16.9. If history is any guide, future stock prices will likely fall, as peak valuations are frequently followed by stock price declines.
The problem with market valuations is that they don't tell us when that will happen. As John Maynard Keynes, the revered British economist and founder of Keynesian economics, once said, "markets can remain irrational longer than you can remain solvent."
In other words, the market might be overvalued now, but prices can take their sweet time before returning to fair valuations. If you sell as soon as the valuation metrics suggest the market is overpriced, you could miss out on years of investment growth.
Price-peak earnings. To put that possibility in perspective, consider what another variation of the P/E ratio tells us. The price-peak earnings ratio is a favorite metric of Robert Drach, founder of Drach Advisors in Tallahassee, Florida, and a commentator on PBS's Nightly Business Report. This derivation of the typical P/E ratio uses the most profitable 12-month earnings period in history as the denominator.
"Today, earnings are setting a record high, so the price-to-peak-earnings ratio is the same as a trailing P/E ratio. At today's prices, that means we are sitting at a trailing P/E multiple above 24," says Drach.
By this metric, markets are widely overvalued. Drach's research has shown this valuation multiple to have surpassed 19 on only four occasions: 1929, 1961, 1987 and 1996. "Some of those markets had considerably more upside, but each ended disastrously, with stock prices lower in the future," Drach says.
The Buffett Valuation Indicator, market cap to GDP. The favorite market valuation tool of legendary investor Warren Buffett bears his name. Known as the Buffett Valuation Indicator, the ratio of the S&P 500's total market cap to the U.S. gross domestic product also indicates a widely overvalued market.
Since 1950, the current 142.1 ratio was only topped once before, in 2000, when the ratio hit 151.3, according to Jill Mislinski, a research director at Advisor Perspectives, an interactive publisher for financial professionals. As any student of market history knows, the bursting of the dot-com bubble in the early 2000s brought waves of investment pain to stocks. In fact, this valuation ratio plummeted to 72.6 percent in 2003, before the stock market rebounded.
Wilshire 5000 to GDP. A variation of Buffett's valuation metric replaces the numerator with the value of the Wilshire 5000, a market index of all U.S. public companies, and leaves the denominator as the nominal quarterly GDP. This ratio darkens the market valuation picture even more, rating the current market as the most overvalued since 1971, according to the Federal Reserve Bank of St. Louis. The ratio stands at 1.695 today in contrast with the 1971 value of 0.253.
The regression to trend. Historically, overvalued stocks eventually have become undervalued, and vice versa. The regression-to-trend market valuation ratio measures the distance on a graph of the S&P 500's value from its moving average or trend line. To create the trend line, a statistical regression analysis incorporates all the values of the S&P 500 over a certain period.
The regression to trend line shows the market as overvalued for the past two decades, except for March 2009, when it briefly dropped 15 percent below the trend. As of early May 2018, the market was 111 percent above the trend, surpassing the 60 to 90 percent range it's danced around for 37 months, according to Mislinski.
In another dire market warning, the S&P 500 would be valued at 1,280 if it was directly on the trend line, as opposed to the current 2,770.
The Fed Model. There is one contrarian metric that doesn't indicate an overvalued market. Named by Ed Yardeni, president of Yardeni Research, an investment strategy and research firm in New York, after a 1997 Federal Reserve Board report mentioned the ratio, the Fed Model compares the S&P 500's earnings yield to the yield on long-term U.S. government bonds. The earnings yield is simply the reverse of the P/E ratio -- earnings per share divided by price.
That number is then compared with the 10-year U.S. government bond yield. When the earnings yield exceeds the yield on the 10-year Treasury bond, stocks are cheap. When the 10-year Treasury yield surpasses that of the S&P 500 earnings yield, stocks are expensive.
Today, the 10-year Treasury yield is 2.92 percent, and the S&P earnings yield is 3.97 percent. Using the Fed Model, you could say that the markets are a good buy, at least when comparing stock market yields to bond market yields.
The market looks less positive if you consider the earnings yield alone. The mean S&P 500 earnings yield is a much more attractive 7.38 percent than the paltry 3.97 percent today.
[See: 9 ETFs for Nervous Investors.]
Historical comparisons can only go so far. Although Scott Welch, chief investment officer at Dynasty Financial Partners in New York, says the market isn't cheap, he doesn't see a sell-off coming in the next six months but concedes there's plenty of uncertainty ahead. "We remain in uncharted waters from an economic policy perspective, as heavy fiscal stimulus in the U.S. battles against tightening monetary policy," Welch says.
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