Assessing the Market's Current Valuation

There are many ways to assess whether the market is undervalued or overvalued. And after looking at all the available data, analysts would still disagree. We will look at a variety of fundamental and technical market indicators and try to determine if the preponderance of the evidence weighs in one direction or the other.

Fundamental Overview

Key fundamental ratios for the major indexes are shown in Table 1. A simplistic analysis shows that the P/E ratios are below the historic average level for all indexes, however yields are still relatively low by historic standards.

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Table 1: data as of market close, Feb 13, 2009 source: Yahoo! Finance

Interestingly, the fundamentals indicate that investors have an appetite for risk. Tech stocks and small caps are being rewarded with the highest P/E ratios and these stocks deliver the lowest yields. Investors are pricing large cap stocks with higher yields more conservatively, possibly indicative of the uncertainty.

Of course, such a simplistic interpretation is not sufficient for market analysis. Stock prices discount the future and should trade based upon what earnings will be over the next few years. The picture here may be grim.

Merrill Lynch analyst David Rosenberg recently revised his earnings forecast for S&P 500 stocks down to $28 in 2009. That puts the P/E for the S&P 500 at 29.5. He also projects operating earnings of $55 for 2010. He wrote:

“For those looking for a silver lining, at least we are going to have a deeper bottom to bounce off. Applying a classic recession-trough multiple of 12x against a forward EPS estimate of $55 would imply an ultimate low of 666 on the S&P 500, likely by October if our estimate of the timing for the end of the official downturn is accurate.”

His forecast represents a possible 20% decline in the stock market from current levels.

Applying Rosenberg’s estimate to a different valuation model offers a slightly more bullish scenario. The “Fed model” uses the interest rate on the ten-year Treasury note to develop a market forecast. The current yield of 2.88% implies that the market can support a P/E ratio of 34.7 for 2009 earnings. This gives a fair value of 971 on the S&P 500, or more than 17% higher than the current level. However, there is an average 16% risk premium priced into stocks according to this model, which places the current level of the S&P 500 at fair market value.

Looking at valuation models applied to individual stocks, there is some room for optimism. Again relying on simple approaches, we find that there are about 2000 stocks trading below their historic fundamental values. Specifically, 2010 stocks have a P/E ratio less than the average P/E ratio they have traded at in the past five years. This is more than half of the 3,970 stocks that have a P/E ratio greater than 1, indicating they have earnings over the past year.

Using the P/S ratio to measure fair value, we find that 8,211 stocks have reported at least some sales in the past twelve months. (As an interesting trivia note, there are more than 1,200 listed securities with no sales at all in the past year.) Of companies with sales, 5,054 (61.5%) are trading below their average P/S ratio.

Growth investors often look for “Growth at a Reasonable Price” (GARP) and try to buy stocks whose earnings growth rate is greater than their P/E ratio. There are 1,677 GARP buy candidates.

Overall, we conclude that market valuations are not excessive and there are a surprising number of stocks that should interest value and growth investors at current levels.

Disclosure: No positions

Comments

[Fred Voetsch:]

I usually am polite but I have to call you either a liar or ignorant for saying:

"Key fundamental ratios for the major indexes are shown in Table 1. A simplistic analysis shows that the P/E ratios are below the historic average level for all indexes, however yields are still relatively low by historic standards."

Look at The Wall Street Journal's data at tinyurl.com/dc9hr6

P/E ratio for the S&P 500 is 23

P/E ratio for DJIA is 18

P/E ratio for NASDAQ is 27

Please use standard data instead of forward earnings or whatever you are using because you are misleading people.

One must also deal with what is and not just what one knows. Past earnings were largely from financial institutions and they spread the wealth around and now that wealth is vanishing at a rate of billions of dollars per day.

We are in a generational correction and a secular bear market that will take over a decade to complete and anyone who listens to your incompetent "data" will lose most of what they have.

Feb 17 01:06 PM

[Fred Voetsch:]

I always find it funny when people like Larry Kudlow pull "data" out of their backsides to prove what they need to prove and that's what you're doing here.

Good luck in the soup line.

Feb 17 01:10 PM

[CautiousInv...:]

I don't know from what sources the author is obtaining his data.

Trailing as reported earnings for the SP500 are now estimated to be $28.60 which, with the SP500 trading at 800, makes the P/E ratio 28 compared to a recent historical average of 18.

David Rosenberg of Merrill Lynch forecast for as reported earnings for 2009 is now down to $28. That puts the P/E for the S&P 500 looking forward at 28.

He also projects "operating" earnings to be $55 for 2010. And, quoting him:

"For those looking for a silver lining, at least we are going to have a deeper bottom to bounce off. Applying a classic recession-trough multiple of 12x against a forward EPS estimate of $55 would imply an ultimate low of 666 on the S&P 500, likely by October if our estimate of the timing for the end of the official downturn."

Feb 17 01:38 PM

[Schweizer:]

You need to use forward 12-month as reported GAAP earnings as published by the S&P. They are now reported at $32.41 as of 2/12. Historice Bear Market lows are at a PE of 9.17, an average of all the Bear lows from 1930.

32.41 x 9.17 = 297 for the SP500. Now that is FAIR VALUE.

Feb 17 06:42 PM

[DavyJ:]

You said: "Using the P/S ratio to measure fair value, we find that 8,211 stocks have reported at least some sales in the past twelve months. (As an interesting trivia note, there are more than 1,200 listed securities with no sales at all in the past year.)"

I ask: Would you please read that again, and again, and even again if necessary.

Then tell us what you really meant to say.

Feb 17 08:31 PM

[AJB7:]

Part of the confusion in discussing the SP500 PE ratio is whether one is using 12 month trailing or 12 month forward estimated earnings and whether earnings are measured by net operating income or reported (GAAP) income. Furthermore, since earnings are only reported or estimated for 4 dates (end of quarter) per year, but there are about 250 days of prices during the year, one can generate quite a variation of PE ratios!

To clarify this matter, let's use source data from the S&P website itself with derived PE ratios in parentheses.

SP500 PRICE 12/31/08 2/17/09 20 year average
903 789

Op Earn 2008 $55.37. (16.3) (14.2) (19.3)
GAAP 2008 $27.72 (32.6) (28.5) (22.7)

Op Earn 2009(E) $67.55 (11.7)
GAAP 2009(E) $32.42 (24.3)

In interpreting this table one has to make a decision whether to use operating earnings or GAAP, but the preference seems to be to use operating earnings since this is believed to give a truer representation of the ongoing health of a company (and also is more stable historically since GAAP includes one time charges which fluctuate with the economy itself). Concerning trailing or forward earnings, both are important since one tells what investors have accepted historically as a standard, while forward earnings provide a guide whether current prices are below or above that standard.

If we accept David Rosenberg's standard that 12x Op Earnings are a good base for a recession trough, then the current SP500 price is at or near the bottom with a foward earnings estimated PE of 11.7. He himself, however, believes that consensus estimates of earnings (which the S&P uses in the above table) is too high, and he prefers $55 which means that the forward estimated earnings PE at current prices is only 14.3. Therefore he believes the SP500 has lower to go. There is some research that does suggest that consensus estimates of forward earnings over one year have been historically too high by about 9% and so Rosenberg is leaning in the right direction all else being equal.

If you believe that forward estimated earngings are too high (as I believe - analysts are micro estimators by profession and the addition of micro estimates does not make a macro one) then by how much? Clearly, this is not an ordinary recession and many questions remain difficult to evaluate (will the stimulus too large or too small, will it work as implemented, are we facing a Japan style "lost decade", are we entering a "beggar thy neighbor" world trade cycle, etc). So, however you use SP500 PE ratios, be especially careful here. The water is very deep. .

Feb 18 12:36 AM

[AJB7:]

Note: I am sorry that when my table got uploaded to seekingalpha, the process distorted the columns so it may not be easy to read as intended. Too bad, it was originally a clear and informative table and really the heart of what I had to say.

Feb 18 12:43 AM

[AJB7:]

I tried to upload the table in Excel format. If this doesn't work I give up. Sorry.

12/31/2008 2/17/2009 20 year average
SP500 Price $903 $789
PE/ PE/ PE/
OP Earn 2008 $55.37 16.3 14.2 19.3
GAAP 2008 $27.72 32.6 28.5 22.7

OP Earn 2009 (E) $67.55 17.7
GAAP 2009 (E) $32.42 24.3

Feb 18 12:55 AM

[Mike Carr:]

A lot of stocks are trdaing below their their average P/S ratio. And more than 1200 stocks reported zero sales in the past 12 months - seems interesting to me that so many stocks exist given all the emphasis on fraud in teh current market. Could be indicating that investors still seek risk?


On Feb 17 08:31 PM DavyJ wrote:

> You said: "Using the P/S ratio to measure fair value, we find that
> 8,211 stocks have reported at least some sales in the past twelve
> months. (As an interesting trivia note, there are more than 1,200
> listed securities with no sales at all in the past year.)"
>
> I ask: Would you please read that again, and again, and even again
> if necessary.
>
> Then tell us what you really meant to say.
>

Feb 18 09:02 AM

[kelm:]

You can look at whatever measure of US markets in isolation you want to - it is meaningless data. In order to determine if US equities are worth getting back into you need to thoroughly look at the world markets in total for a confirming signal. This is a global crisis in a global economy. Wall Street stock myopia led far too many investors to the slaughter. One also needs to look at the credit markets and what they tell us about the companies in the market and their customers and markets. Doing that in 2007 would have saved people a bundle.

The days of looking at US stocks in isolation are over but the financial adviser community hasn't figured that out yet.

Feb 18 10:32 AM

[DavyJ:]

Mike, What do 1200 companies that have zero sales do? I.e., how do they make money and how do they stay in business?


On Feb 18 09:02 AM Mike Carr wrote:

> A lot of stocks are trdaing below their their average P/S ratio.
> And more than 1200 stocks reported zero sales in the past 12 months
> - seems interesting to me that so many stocks exist given all the
> emphasis on fraud in teh current market. Could be indicating that
> investors still seek risk?

Feb 18 02:34 PM

[Mike Carr:]

They are 'penny stocks' that don't make money and eventually go out of business - taking investor dollars with them.


On Feb 18 02:34 PM DavyJ wrote:

> Mike, What do 1200 companies that have zero sales do? I.e., how do
> they make money and how do they stay in business?

Feb 18 04:11 PM

[Erick Tippett:]

Dear Sir:

A number of analysts and experts such as Robert Prechter have contended
for quite some time now that stocks have been ridiculously overvalued since
the fed headed off what should have been the end of a bull market that got
extended from 2001 to 2007 with interest rate, monopoly money
tampering tactics!

Your data doesn't make sense to me!


EDT
Chicago, Illinois

Feb 18 06:30 PM