Is the Stock Market Over- or Under-Valued?

The giant swings of stock markets up and down sometimes are justified, sometimes not. How to tell the difference is key, since the unjustified movements eventually get corrected. Markets have a decided tendency to return to long term averages when it comes to returns and prices.

Why Should You Care? - A couple of reasons make the question of stock market valuation significant to the investor.

1. Valuation can set more realistic expectations as to future returns. Researchers have found that periods of too-high valuation are followed by extended periods of lower returns. For example, The P/E Ratio and Stock Market Performance by economist Pu Shen of the Kansas City Federal Reserve, graphs the fact that the higher the stock market valuation according to the ratio of Prices to Earnings (P/E), the lower the returns in the following ten years, or vice versa, low valuations mean higher returns in future. N.B. A look at the graph tells us that the relationship is generally true, a tendency, with quite a bit of variation and it can take years to come about, which means we must admit caution in forecasting the future from today's situation. Yale professor Robert Shiller, published similar results in his famous book Irrational Exuberance.
2. If stocks are under-valued it may be a good time to buy, or if over-valued, to sell or to wait for a better moment. The book Yes, You Can Time the Market! by Ben Stein and Phil DeMuth shows that it is possible to get a higher long run investment return by using various valuation indicators. The only problem may be that one may have to wait many years for an indicator to turn strongly positive. The extreme example is that an investor would have had to wait a full 17 years between 1984 and 2001 for the buy signal. During that time, the S&P 500 went up enormously. On the other side, the "don't buy" signals of the tech bubble years around 2000 would have been well-heeded.
   

Current Valuations
Two stock market indices of prime interest to Canadian investors are Canada's TSX Composite and the S&P 500 of the USA. Below is a sampling of recent assessments of the correct valuation of the overall level of stock prices.

• TSX Composite - InvestorsFriend.com judged as of late December 2009 that the TSX at 11,555 was "about fairly valued" using a bottom-up assessment of P/E. He also concluded that it was priced to return about 7% per year over an expected 10 year holding period, which seems a reasonable return, though it is before inflation and taxes.
  
• S&P 500 - Yes, You Can authors Stein and DeMuth figure the current real inflation-adjusted S&P 500 price gives a green buy signal but other indicators like P/E, Dividend Yield and Earnings Yield to AAA Bond Ratios are red. They do say in their book that one indicator being green while others are red still offers a buying opportunity, just not as strong. Shiller's Cyclically Adjusted P/E (CAPE) Ratio, which takes an average of the past ten years of earnings to smooth out recessions and booms, shows the beginning of February ratio to be 19.6 (see his downloadable spreadsheet, updated monthly), which is above the long term average for the S&P of about 16. That means his estimate is that the S&P is overvalued. In early December 2009, when the S&P was at 1102 (vs 1065 on February 11th), Andrew Smithers of Smithers & Company figured that it was quite over-valued according to CAPE and another metric, the q ratio, which compares the replacement value of corporations with their total stock market value.
  

It can pay to examine and learn from the past. George Santayana's famous words apply also to investing - "Those who cannot remember the past are condemned to repeat it."

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.