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Market Outlook: Are Stocks Overpriced at All-Time Highs?

Michael J. Carr

The Dow Jones Industrial Average reached a new all-time high and the S&P 500 is close to a record high. New highs are often followed by even more new highs, and although a short-term pullback is possible, stocks are completing the fourth year of a bull market that could have much more upside.

Stocks Do Not Appear Overpriced at All-Time Highs

SPDR S&P 500 (SPY) gained 2.19% for the week, putting it within 1.5% of a new all-time high. We have now gone 39 weeks without a 10% correction, the third longest such stretch since this bull market started in 2009.

SPY Market Outlook Chart

With the S&P 500 index reaching new all-time highs, it's a good time to consider what the index might be worth based on fundamentals. This problem can be addressed a number of ways, but I like to keep things as simple as possible. Let's start with earnings and then look at what the right price-to-earnings (P/E) ratio should be. The fair value of the index is simply equal to earnings times the P/E ratio. This is a simplistic but useful approach.

The earnings estimates in the table below are provided by Standard & Poor's. They are just as likely to be right as any other analyst is, and just as likely to be wrong. These estimates will be used to estimate the fair value of the index.

S&P Earnings Estimates

Over the long term, the average P/E ratio for the market has been 15. We could also use the projected earnings growth rate as the appropriate P/E ratio (15 for this year and 12 for 2014). Some analysts believe that the P/E ratio should be based on the current interest rate. With long-term corporate bonds yielding about 4.8%, the interest rate should be about 20 under this theory.

Based on earnings reported over the past 12 months, the S&P 500 is trading at 16 times earnings. This ratio is close to the long-term average, is about equal to the expected earnings growth, and is low based on interest rates. It seems safe to say that stocks are not overpriced at the current level. An economic downturn would change that, but for now, stocks do look like they could continue higher this year.

While we could argue for a higher P/E ratio, using a value of 15 is the more conservative approach. Based on expected earnings, we could argue that the S&P 500 is worth 1,669 this year (15 times expected earnings of $111.27). That indicates stocks could appreciate from their current levels.

Prices never move in a straight line and there will be consolidations and dips in the market. For now, there are no indicators pointing to a large decline. Sell-offs should be viewed as opportunities to buy stocks.

Midcap stocks seem to be the strongest right now, with tech being the strongest sector. I'll cover a few specific names early next week.

Recommended Trade Setup:

-- Long SPY at $155
-- Expect volatility and use a wide stop-loss, initially set at $145
-- Set initial price target at $158.20, but expect further gains from there

Gold's Relative Strength at 0 for Seventh Week in a Row

SPDR Gold Trust (GLD) gained 0.17% last week after closing down for three weeks in a row. The small price gain did nothing to improve the technical picture in GLD. Relative strength (RS) remains at 0 (I use a 0 to 100 scale for this indicator with 0 being the weakest).

The chart below is compressed to show as much data as possible. It also uses gold futures to obtain a longer history. GLD has only been trading since 2004 while futures data goes back to 1975. RS looks the same for both the futures contract and the ETF since 2004.

In the chart, we can see RS spikes from low to high values. Owning gold only when RS is above 70, indicating that a gold investment is outperforming 70% of stocks and futures, would have avoided bear markets in the metal. You would have been invested only one-fourth of the time but would have beaten a buy-and-hold investment in gold with less risk.

Gold Market Outlook Chart

Until RS on GLD improves, there is no reason to be a buyer.

PowerShares DB Gold Short ETN (DGZ), an inverse fund that goes up when gold prices fall, lost 0.16% last week but is still a hold.

Recommended Trade Setup:

-- Buy DGZ on dips below $12.25
-- Maintain stop-loss at $11.75
-- Maintain price target at $14

This Week's News

Economic news has been surprising to the upside and many revisions to the data have also been positive. Perhaps the biggest surprise last week was when PIMCO's Bill Gross raised his estimate of GDP growth to 3% for the year. Gross has been bearish on the economy and this represented a significant change in his outlook.

Gross is a smart investor and is worth paying attention. Growth of 3% could push stocks higher. Gross also said he expects nominal GDP growth, which includes inflation, to be about 5%, implying inflation of about 2%. With official inflation data due out this week, we will get our first chance to see if Gross is likely to be right.

Michael J Carr Market Outlook News

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