Seeking Alpha
Profile| Send Message| ()  

With the S&P 500 (SPY) and the Dow Jones Industrial Average (DIA) ascending through their historical highs many investors are wondering whether the stock market is overextended and will correct by any significant amount.

I believe there are a few ways to evaluate the decision to buy or sell the market at this stage, but let me start by saying that nobody can perfectly time the markets on a short-term basis. So while you might feel strongly one-way or another, an experienced investor will realize that the market can remain irrational longer than an investor can remain solvent.

Nonetheless, here are a few key points outlining why the market may or may not be overextended.

1. The Economy

While many people remain unconvinced there are numerous signs that the economy is in a steady recovery.

The broadest measure of economic health, real GDP, has been growing steadily since it bottomed in early 2009. The first chart below shows GDP on a longer term basis to highlight the transient nature (although it definitely didn't feel transient) of the last recession. The second chart zooms in on the last five years to show just how far we have come back. Not only have we recovered everything we lost during the recession, but the real economy is actually about $300 billion larger than it was five years ago, prior to the recession.

(click to enlarge)

(click to enlarge)

This recovery is filtering its way throughout the broader economy, impacting the jobs market. While many new jobs aren't high quality, employment across the country has been steadily rising since 2010 (see first chart below).

In fact, total wages paid to all employees has risen and actually surpassed previous peaks, as seen in the second and third charts below. While distribution may not be even, money is in fact flowing to the civilian population. The infamous U-6 rate (the unemployment rate that includes 'under-employed' workers) validates this point, as it also has improved steadily since hitting a peak in 2010 (see fourth chart below).

(click to enlarge)

(click to enlarge)

(click to enlarge)

(click to enlarge)

What about the segment of the economy that started it all? The health of the housing market has a massive ripple effect on the broader economy because it creates jobs, stimulates demand for 'white' goods and generates a wealth effect on existing homeowners. Household formation, house purchases and housing prices all have a significant impact on the US economy.

While Robert Shiller himself is not 100% convinced that housing is as strong as it looks, the data at least indicates that the market has stabilized. The chart below shows the Case-Shiller Home Price Index, which clearly has flatlined while the previously-mentioned economic indicators have improved. This helps validate the hypothesis that a stable-to-growing housing market will/is providing a massive tailwind to the US economy.

(click to enlarge)

The broader 'All Transactions' price index (chart below) supports the data presented in the Case-Shiller Index. While the timing might be slightly different, the 'All Transactions' index also shows that housing prices have stabilized.

(click to enlarge)

Housing prices are being supported because more families are buying homes. From my point of view, I see an increasing number of families - particularly children of immigrants seeking the American 'dream' - that are interested in buying homes. This is showing up in the Housing Starts data (chart below), which has steadily climbed as housing prices have stabilized.

(click to enlarge)

Why are people interested in buying houses? Affordability. Manipulation or not, the Fed has done a great job pushing 30 year mortgage rates to rock-bottom levels. For those that qualify (and banks are gradually easing lending conditions), 30 year mortgages are available at historically cheap rates (see chart below). Cheap financing combined with cheap prices has resulted in record-high housing affordability (second chart below). Consequently, housing will likely continue to be a positive contributor to the US economy.

(click to enlarge)

(click to enlarge)

2. Corporate Health

Any investor worth his salt knows that stock market performance depends more on corporate health than it does economic. While economic growth feeds into corporate profits over the long term, companies can far outperform the broader economy in the medium term. Often corporate performance is paradoxically driven by the very elements that ail the economy. For example, while unemployment is a negative for the economy, businesses that learn to operate with fewer employees can increase productivity, cut expenses and improve cash flow.

Furthermore, the circumstances that cause an economy to contract can also lead corporate executives to become more conservative in how they manage businesses going forward. The following chart illustrates just how far corporate profits have risen. In fact, corporate profits are about 30% higher than they were at the last peak in 2007.

(click to enlarge)

Profits haven't grown at the 'expense' of leverage. In other words, corporate profits are not being driven by excess risk-taking and exposure to the business cycle. As an illustration, the chart below shows that corporate debt as a proportion of equity (i.e. the debt-to-equity ratio) has declined considerably over the past few years. Conclusion: Business are making lots of money and are being run quite conservatively.

(click to enlarge)

3. Valuations

When evaluating whether to buy or sell the market, one should not look at where the index is or has been. One must consider where it may go. Earnings growth and valuations will determine this, not an arbitrary index level. As illustrated above, corporate earnings are growing quite nicely in aggregate. So are valuations expensive?

According to the standard P/E ratio for the S&P 500, the market doesn't appear terribly expensive. The chart below shows that it currently sits at 17.96 times earnings, which is on the higher-end of the normal band historically but not necessarily a market-stopping figure. It's long-term average is 15.49 times earnings.

S&P 500 PE Ratio Chart

(Chart source: Multpl.com)

Meanwhile, the 'Cyclically Adjusted P/E Ratio' for the S&P 500 is showing a figure of 23.22. This is on the higher-end of the historical range (above the average of 16.47). However, this is not a shockingly high figure.

Shiller PE Ratio Chart

(Chart source: Multpl.com)

On a price-to-book ratio basis, the S&P 500 again doesn't look overvalued. As you can see in the chart below, the measure has declined considerably since its peak during the tech bubble. On a price-to-book basis, the market today is almost as cheap as it was during the height of the financial crisis.

S&P 500 Price to Book Value Chart(Source: Multpl.com)

Finally, I like to look at the market's dividend yield as part of the valuation analysis. The following chart plots the S&P 500 dividend yield going back to 1871. It is clear that in terms of dividend yield the market isn't as attractive as it was throughout much of its history. However, one must evaluate this with the knowledge that dividend payout ratios have declined as well. Dividends are only a portion of a firms cash flow that is available to shareholders so it doesn't tell the entire story.

S&P 500 Dividend Yield Chart

(Source: Multpl.com)

Conclusion

I believe that the market rally of the past few years is based on improving economic and corporate fundamentals. Whether those fundamentals are based on hot air coming from central banks is irrelevant to the investor wishing to make money on the markets. The fact is that what the Fed is doing (i.e. buying assets) is having an impact on the bottom line for the economy and businesses. You can either choose to sit on the sidelines for philosophical reasons or participate and make money. Those that have participated have been rewarded handsomely.

This brings us to today. With the housing market potentially starting a long-term upward climb I believe that the positive knock-on effects in the US could work in the investor's favor. However, I also believe that the market - while not exorbitantly priced - is not a screaming buy based on current valuations. This doesn't necessarily mean the market must/will correct to move in-line with historical averages. It could mean that corporate profits catch up while the market oscillates around a trading range. For the long-term investor willing to wait out some volatility, this may not matter.

Personally, I wouldn't chase the market at this point. But, given my long-term view, this is not stopping me from selectively adding exposure to companies trading below the market p/e with a solid history of growing earnings and dividends.

Source: Is The Stock Market Still A Buy?