Is the Market Overvalued?

Great investors tend to focus on investing in one company at a time (bottom up) and ignore macroeconomic and macro-market forcasts (top down), but the CAPE and Tobin’s Q ratio are remarkably good at predicting long-run returns for the US equity market.

From Mark Hulbert’s US Stocks View column¬†in today’s Dow Jones NewsPlus:

(I)t’s hard to slice and dice the data in a way that shows stocks to be undervalued right now.

Let me present the data, and then respond to some of the ways in which investors recently have been trying to wriggle out from underneath the sobering conclusion the data are painting.

Let’s start with the current P/E for the S&P 500 index, which stands at 16.1 when calculated using trailing 12-month as-reported earnings. This is about 5% above the long-term average for this ratio back to 1871, which is 15.5 according to data supplied by Yale University finance professor Robert Shiller.

To be sure, the one-year P/E ratio is quite volatile, and its track record is rather mixed. For this reason, many researchers have followed the lead of Shiller and Harvard professor John Campbell and focused on a modified P/E ratio whose denominator is average inflation-adjusted earnings over the trailing 10 years. This modified ratio is sometimes called CAPE (for Cyclically Adjusted Price Earnings ratio). The CAPE has a markedly better forecasting record than the simple P/E.

The current CAPE, according to Professor Shiller’s data, is 22.7.That’s 38% higher than this modified ratio’s long-term average of 16.4.

On both counts, therefore, it’s hard to argue that stocks are undervalued. And, at least when focusing on the CAPE, it actually looks as though stocks are downright overvalued.

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