Is the Stock Market Currently Overvalued?

The S&P 500, a broad market index, has increased in value an impressive 185% since March 2009. Does that mean that the rally is over and that it’s too late to buy stocks at these valuations? The truth is, the broad market valuation can’t help you to make individual investment decisions. There are always opportunities to be found regardless of what the overall market is doing or has recently done. However, it can be helpful to understand where the overall market may be headed as that can help to provide even better buying opportunities as a large sell off can affect the prices of even the most undervalued companies at any given time.

The most common valuation metric is the P/E ratio, or Price to Earnings Ratio. This ratio shows how much an investor is willing to pay per dollar of earnings. A ratio of 10 indicates that an investor is willing to pay $10 for $1 of current earnings. The S&P is currently trading around 19x trailing earnings vs. an average multiple of 16x since 1871. While this suggests an overvaluation, ratios above 20 are not unheard of. The market traded above 20 through most of the 1990s eventually peaking above 40. Of course that proved to be the breaking point of the dotcom bubble and was followed abruptly by a stock market crash. The point is, while the current market is at a historically above average valuation it is nowhere near uncharted territory. And in today’s record low interest rate environment, one might even argue that it is closer to fair value rather than overvalued. The following chart shows how the current P/E ratio compares to historical valuation:

S&P 500 PE Ratio

S&P 500 PE

 

Another valuation method would be the P/B ratio, or Price to Book Value Ratio. Book value is the total value of a company’s assets that shareholders would theoretically receive if a company were liquidated. Currently, the S&P 500 P/B is 2.72, meaning it is valued at 2.72 times the underlying assets. This valuation happens to fall right in line with the median value. A record low P/B value of 1.78 was reached in March 2009 while a record high of 5.06 occurred in March of 2000. Based on this number alone, the market would appear to be perfectly valued at it’s current level. The following chart shows the P/B value over the past 15 years:

S&P 500 Price to Book Value

 S&P 500 PB

An additional consideration is the fact that most investors are still underweight in stock ownership despite the markets reaching record highs and its historic run over the past 5 years. There is an estimated $90.6 trillion in global investable assets. Of that amount only 37% is currently invested in equities, the lowest amount since 1959. The highest allocation ever reached was 64% on two separate occasions, both of which marked the tops of the two bull markets ending in 1968 and 1999. Based on this fact there appears to be a lot of individuals who have missed out on the recent rally.

Valuation appears to be slightly above historic norms. However, in a 0% interest rate environment investors have limited options to earn income from their investments. With the country’s largest generation, the baby boomers, reaching retirement age and in need of income; and the fact that they currently appear to be under invested in equities, leads me to believe the market can continue to move higher. While corrections are common, and we are currently overdue for one, the fact remains that this market rally could continue to run much longer than most expect. This belief is not to suggest that you should throw caution to the wind and blindly buy just any market or sector but it does suggest that if you haven’t participated in the rally since 2009 due to fear it may not be too late.

 

This article contains the opinions of the author but not necessarily the opinions of Vulcan Investments, LLC. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.