Stocks still aren’t even close to being cheap
Even with the recent plunge, the stock market has a long way to fall before stocks are even fairly valued, much less undervalued.
That is the depressing, but nevertheless undeniable, conclusion to emerge from a review of where six well-known valuation indicators currently stand. Each shows that recent weakness has done little more than work off some of the extreme overvaluation that previously existed.
To be sure, valuation indicators’ track records do a far better job forecasting the market’s direction over the intermediate and longer terms than they do as short-term market-timing tools. So the market is entirely capable of rising this year in the face of the current overvaluation.
But you may recall that it was precisely one year ago that I last reported on the stock market’s valuation, and since then the Dow Jones Industrial Average has fallen 7%.
Consider the same six valuation indicators that I focused on in my year-ago column. As I did then, the list below contrasts their current readings to where they stood at all of the bull-market tops since 1900 (using the bull-and-bear-market calendar employed by Ned Davis Research).
As you will see in the listing below, the indicator that judges the stock market to be least overvalued is still showing that equities are more overvalued than at 71% of past bull-market peaks.
The other five of the six indicators show today’s market to be more overvalued than at between 82% and 89% of those peaks:
1. The price/book ratio, which stands at an estimated 2.6 to 1. The book value dataset I was able to obtain extends only back to the 1920s rather than to the beginning of the century, but at 23 of the 28 major market tops since then, the price/book ratio was lower than it is today.
2. The price/sales ratio, which stands at an estimated 1.1 to 1. I was able to put my hands on per-share sales data back to the mid-1950s; at 16 of the 18 market tops since, the price/sales ratio was lower than where it stands now.
3. The dividend yield, which currently is 2.2% for the S&P 500. At 30 of the 35 bull-market peaks since 1900, the dividend yield was higher.
4. The cyclically adjusted price/earnings ratio, which currently stands at 25.9. This is the ratio championed by Yale University’s Robert Shiller. It was lower than where it is today at 30 of the 35 bull-market highs since 1900.
5. The so-called Q ratio. Based on research conducted by the late James Tobin, the 1981 Nobel laureate in economics, the Q ratio is calculated by dividing market value by the replacement cost of assets. According to data compiled by Stephen Wright, an economics professor at the University of London, and Andrew Smithers, founder of the U.K.-based economics-consulting firm Smithers & Co., the market currently is more overvalued than it was at 31 of the 35 bull-market tops since 1900.
6. Price-to-earnings ratio. This is the one that is least bearish, and the one that is perhaps most-often quoted in the financial media. Nevertheless, according to data on as-reported earnings compiled by Yale’s Shiller, and based on S&P estimates for the fourth quarter, the P/E ratio currently stands at 20.1 to 1. It is higher than it was at 71% of past bull-market peaks.
How might bulls try to wriggle out from underneath the force of this data?
One way, up until recently, was to argue that the Federal Reserve’s record-low-interest-rate policy justified higher-than-normal valuations. As I’ve written before, I never thought that was a good argument. Nevertheless, with the Fed’s recent decision to begin raising rates, the bulls can’t fall back on even this questionable rationale.
The bottom line: The stock market has to fall a lot further before the valuation indicators will be blowing in the direction of higher prices.