The Market Is Clearly Overvalued Relative To Earnings Growth

Includes: DIA, QQQ, SPY
by: Kraken

The way the market as been acting, there is a clear reason why investors are concerned. Even after Bernanke announced a possibility of tapering this year, the market didn't get hit as hard as most expected. However, just because the market has been resilient doesn't mean that it is safe to jump in now.

The below chart shows the average S&P average P/E ratio since before 1900. If you look at the entire chart, you will see that there is a range the market generally sits in. The P/E usually was between 22 and 4. There were moments where it did break out of this range. This is due to the tech bubble in 2000. Also in 2009, valuation jumped again to reflect strong expectations of growth. This growth did come to fruition when earnings grew over a 100% (refer to second chart).

Source: Standard & Poors

The current P/E ratio is 18.80, so there is still room to run. If it gets closer to an average P/E of 20 or more, then I would start being somewhat concerned. Normally, when the overall market maintains a P/E as high as this, there needs to be earnings growth to back up the valuation. This is simply not the case.

Source: Standard & Poors

Earnings growth is essentially flat to declining now. This is concerning, given the moderately high valuation that currently exists. Please note that even though these are trailing numbers, the expectations going forward are still relatively weak.

Thomson Reuters has actually provided an unique chart that actually shows the negative earnings announcements relative to positive announcements. Also known as the N/P ratio.

The long-term average has generally been around 2.5. In Q2 2013, it is expected to be over 6. This is a huge difference. Obviously earnings are much better than they were in 2009, so the only explanation is that analysts have simply gotten ahead of themselves.

I consider myself a long-term bull, but I am also a realist as well. The current valuation is getting hot and the earnings are not supporting it. I believe the U.S. economy still has some problems that simply cannot be ignored. The debt is still heavy and nobody officially knows how a strong rate increase would impact the markets.

I am still hearing plenty of commentary from analyst with insanely bullish predictions. Credit Suisse has just boosted their S&P target to 1,900 by the end of 2014. This is more than 16% return on the index. CS stated the following:

Global macro momentum has slowed sharply between March and early May, just as it did at the beginning of 2010, 2011 and 2012. In those cases, the slowdown in macro momentum turned out to be quite sharp, leading to significant corrections in the equity market.

Now I don't completely understand what Credit Suisse actually considers to be a "significant" correction, but I fail to understand the logic behind a 1,900 S&P target. This prediction should show you that there is an abundant amount of optimism.

Investors should be cautious and should partially liquidate some of their holdings just to play it safe. If the market does see a decent correction, you will have the opportunity to buy in at a lower point. The overall market valuation relative to earnings growth is simply just too rich at this point.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.