Is the Stock Market Overvalued?
My opinion is yes. This post will explain how I came to this conclusion. Thanks to reader Bricks for bringing up this topic.
We’ll be looking at the S&P 500 because it’s a popular index and there’s a lot of data available for it. 🙂 This index basically represents a basket of 500 large publicly traded companies in the United States. We can analyze the following 7 metrics to determine how cheap or expensive the market is. And naturally each of these ratios below can be applied to individual stocks as well. 😉
- Trailing P/E ratio
- Forward P/E ratio
- Forward P/S ratio
- Price vs Forward Earnings
- Shiller P/E Ratio
- Operating Margins
- EV / EBITDA ratio
Useful Ratios to Value the Stock Market
1) P/E Ratio – The price to earnings ratio, or sometimes known as the trailing P/E ratio or TTM P/E ratio, is a popular measurement to help determine the valuation of stocks. A low P/E ratio signals a cheap valuation. Historically the P/E ratio of stocks in both Canada and the U.S. hover between 10 to 20 most of the time. However, as of today the P/E ratio of the S&P 500 index is about 22, which signals it is overpriced relative to the norm. (image source)
2) Forward P/E Ratio – Unlike the trailing P/E ratio, the forward P/E ratio uses projected future earnings. Of course nobody knows how much money companies will make in the future, but this metric provides a sentiment of how profitable the market feels about the next few earnings seasons. According to a FactSet report, the forward P/E ratio of the stock market is 16.5, which is above the long-term average of 14.2. So based on this data stocks are currently about 16% more expensive than what they should be.
3) Forward P/S Ratio – The price to sales ratio compares the total market value to revenue. It usually moves in the same direction as the P/E ratio but can provide a smoother, more accurate depiction of the market’s valuation (see yellow line in chart above.) This ratio is currently over 1.6x for the S&P 500, which suggests the market is overpriced, even compared to 2008 levels.
4) Price Change vs Forward Earnings Change– The price of the stock market is mainly determined by its future profitability. But recently the price has diverged away from future expected earnings which suggests stock prices are too high.
Notice what happened after the last time price diverged higher from the forward expected EPS in 2006 and 2007. 🙁
According to John Butters, senior earnings analyst at FactSet, for the first quarter of 2016 it appears 92 companies have issued negative EPS (earnings per share) guidance and only 26 companies have issued positive EPS guidance. This depicts a rather bearish outlook. However, stock prices have not come down nearly enough to reflect these estimates. 😕