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Do you think that the S&P 500 is overvalued? While there are many people who believe so for a variety of reasons, one would be hard pressed to think of a sector more dedicated to this view than the metals and mining sphere. Such a prevailing view is not surprising, as so-called "metal heads" tend to view the broader economy in terms of real assets, and are naturally suspicious of activist Federal Reserve policies which have played a big part in the recent equities rally. These people felt largely vindicated by the crash, which proved the inherent riskiness of and difficulty in evaluation complicated structured finance products.

We tried to quantify this view by looking at the S&P 500 as a function of metals prices. Gearing the approach to retail investors, I looked at the SPY ETF as a function of copper and gold ETFs JJC and GLD respectively. Unfortunately, this data only goes back to late 2007, but provides a 5 year sample period and quantifies the pre-crash period and the ensuing stock market recovery.

It turns out that JJC and GLD explain about 58% of the variation in the S&P 500. The dual-variable approach makes sense. Copper tends to be a proxy for industrial growth and gold tends indicate confidence (or lack thereof) in the global economy and currencies. Those who use real assets as a guideline should find a reasonable qualitative basis for this explanatory model. Charting the movement of the actual SPY ETF as opposed to the model produces this graph:

One of the first things you might notice is that the disparity between the two today is roughly the same size as pre-crisis levels. If you're a metals enthusiast, you might conclude that at both intervals, cheap credit was inflating the economy's value as represented by the benchmark index. If you were to chart merely the spread between the two, you would notice that at its height in early 2008, the S&P 500 was about 3 Standard Deviations above its predicted value in terms of gold and copper.

(click to enlarge)

Today, the model suggests a 2.75 Standard Deviation overvaluation and one that is rapidly rising. In addition, the model pinpointed the beginning of the rally in 2011, but has suggested that the market's been overvalued since roughly the beginning of 2013, another widely-held view.

I must caution anyone wishing to draw conclusions from this model given the limited sample size, and the relative lack of boom and bust periods contained within. However, supporting a conclusion held by many, we must note that a real assets-based valuation does not support the soaring heights of the recent equity market rally.

Source: The Real Assets/Equities Disconnect