The Big Picture

April 15, 2011

I was asked recently for our official opinion on the topic of stock market valuations. My answer, in short, was, yes. Yes, the topic of stock valuation can become complicated and/or heated. Yes, stocks are clearly overvalued by some measures. Yes, stocks are only moderately priced by other measures. And finally, yes, they are even undervalued by others still. Thus, Im of the opinion that this topic tends to be used by those analysts looking to either make headlines or to justify their positions.

As I mentioned recently, I have two colleagues that tend to lean toward the dark side (meaning that they like to trade from the short side of the game whenever possible). So, in a not-so scientific study, I decided to ask them their opinion on market valuations.

It probably wont surprise you to learn that these two members of the permabear camp believe that stocks are overvalued at the present time. And to clarify, these two members of the glass-is-nearly-empty club dont just think stocks are a little overvalued. No, these guys say that the market is WAY too high and due to, wait for it crash at any moment! (What, you were expecting a cheery outlook from these two?)

While neither of my friends in the bear camp pointed me to the article, I was directed to a piece written by Mark Hulbert of the Hulbert Financial Digest suggesting that stock valuations currently reside in rarified air if viewed from what Yales Robert Shiller calls the CAPE (cyclically adjusted price earnings) ratio.

Hulbert writes, There have been only four other occasions over the last century when equity valuations were as high as they are now, according to a variant of the price-earnings ratio that has a wide following in academic circles. Stocks on each of those four occasions would soon suffer big declines.

Hulbert goes on to say that the four prior occasions that the CAPE has been at the current level include the late 1920s, the mid-1960s (prior to the 1965-1982 secular bear), the late 1990s, and October 2007.

In an attempted caveat, Hulbert says, To be sure, a conclusion based on a sample containing just four events cannot be conclusive from a statistical point of view. Still, it will be hard to argue that the current stock market is undervalued or even fairly valued.

However, armed with more than one approach to valuation, one might respond with, Au contraire, Monsieur Hulbert.

I have penned several pieces on the subject of market valuations over the past year or so and as such I wont bore you with the gory details of each and every indicator. But in cutting to the chase, it is plain to see that there is more than one side to this argument.

For example, if one uses the median P/E ration of actual GAAP (Generally Accepted Accounting Principles) earnings over the preceding twelve months, it is clear that stocks are fairly valued at the present time. And if youd like to broaden things out and use the ratio of total market cap to corporate profits again, things look fairly valued.

For those of you that prefer the so-called Fed Model, which puts the level of interest rates into the mix, you could provide proof that stocks remain undervalued at current prices.

So, which is it, you ask overvalued, fairly valued, or undervalued? In my humble opinion, the answer lies in the eyes of the beholder. But perhaps the most important thing to understand about the use of valuations in your analysis of the state of the markets is that the ranges of valuation indicators change over time.

If you were to print off the charts of a dozen valuation indicators, you will likely find that the high-to-low range of the indicators changes dramatically as secular cycles come and go. For example, what was overvalued in 1965 and/or 1987 is currently more toward the low end of the range that began sometime in the mid-to-late 1990s.

Because of this, it is important to recognize that the level Mr. Hulbert refers to in his article has been consistently exceeded since the mid-1990s (at least in our version of the Four-Quarter Total Earnings Smoothed over Ten Years) and is now a fair amount below where it was from 2003-2008 and WAY below the level seen in 2000.

So, if I was trying to convince you that stocks were cheap at this point in time (which, I am not) I would merely point to the current level as being one-half of where it was in 2000 and still below the levels seen in 2008. Id then bring it home with the argument that stocks simply cannot be overvalued when studying the data over the past 18+ years.

The main point here is that it is VERY easy to see what you want to see when looking at valuation indicators. And it is for this reason that we dont put much emphasis on any of them in our work. In short, it appears that interpreting valuation measures is more art than science and may be best suited for proving the point you want to prove.

All the best,

David D. Moenning

Disclosure - Mr. Moenning owns positions in securities mentioned: None


  S&P 500 Last 5 Years
Loading chart  2001 TickerTech.com



The analysis and information in this report and on our website is for informational purposes only. No part of the material presented in this report or on our websites is intended as an investment recommendation or investment advice. Neither the information nor any opinion expressed nor any Portfolio constitutes a solicitation to purchase or sell securities or any investment program. The opinions and forecasts expressed are those of the editors of Top Guns Trading and may not actually come to pass. The opinions and viewpoints regarding the future of the markets should not be construed as recommendations of any specific security nor specific investment advice. Investors should always consult an investment professional before making any investment.

Any investment decisions must in all cases be made by the reader or by his or her investment adviser. Do NOT ever purchase any security without doing sufficient research. There is no guarantee that the investment objectives outlined will actually come to pass. All opinions expressed herein are subject to change without notice. Neither the editor, employees, nor any of their affiliates shall have any liability for any loss sustained by anyone who has relied on the information provided.

The analysis provided is based on both technical and fundamental research and is provided as is without warranty of any kind, either expressed or implied. Although the information contained is derived from sources which are believed to be reliable, they cannot be guaranteed.

The information contained in our websites and Top Guns Trading publications is provided by Evergreen Publishing Co. Inc. (Evergreen). One of the principals of Evergreen, Mr. David Moenning, is also President and majority shareholder of Heritage Capital Management, Inc. (HCM) a Chicago-based money management firm. HCM is registered with the U.S. Securities and Exchange Commission as an investment adviser. HCM also serves as a sub-advisor to other investment advisory firms. Evergreen is a publisher and has not registered as an investment adviser. Neither HCM nor Evergreen is registered as a broker-dealer.

Employees and affiliates of HCM and Evergreen may at times have positions in the securities referred to and may make purchases or sales of these securities while publications are in circulation. Editors will indicate whether they or HCM has a position in stocks or other securities mentioned in any publication. The disclosures will be accurate as of the time of publication and may change thereafter without notice.

All indices and returns shown assume reinvestment of dividends and capital gains. Investments in equities carry an inherent element of risk including the potential for significant loss of principal. Past performance is not an indication of future results.

By accepting emails, including various paid subscriptions and free email reports and newsletters, you agree to the terms of this Disclaimer as such may be amended from time to time.



Checks on the "Big Picture" of the Market