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The stock market is in constant conflict between buyers and sellers. Aside from very short-term traders, these purchases and sales are based upon the perceived value of the underlying company being greater or lesser than the current trading price. In aggregate, all these many purchases and sales determine stock prices.

Whether or not the market is very good at accurately pricing a particular stock close to its intrinsic value has been thoroughly debated, but our opinion is that the market gets it wrong many times. An overall bullish sentiment about a particular company will drive its stock price beyond its intrinsic value, while another stock will get hit hard by missed earnings or other pessimistic news.

What drives these wild fluctuations above and below fair value? Two major forces: fear and greed.

Fear and Greed

Many investors get caught up in the dominant market sentiment of the day. When the stock market is going up or down, investors can succumb to the emotions caused by market gains or losses.

In the late 1990s, wild optimism about technology drove ".com" stock prices unjustifiably high. Investors became caught up in the euphoria and a bubble formed. On the flip side, the financial crisis of 2008-09 caused widespread panic in the markets. The psychological toll of watching account values fall pushed many investors to sell at prices already below fair values, driving stocks down to unjustifiable lows.

Are Stocks Too High?

To the extent that fear drove the stock market down in 2008-09, we have said the market would eventually recover and then become overvalued. The stock market isn't overvalued yet, but eventually we believe it will be. At some point in this bull market, investors will begin to feel "bullet proof" again. Stocks as a whole will be driven to price levels that earnings and dividends cannot justify. When that time comes, it will be the investors grounded in fundamental values, not emotion, that will thrive.

The S&P 500 is up well over 100% from its lows in 2009 and touching all-time highs, but there are several reasons we believe it is poised to continue to rise. In addition to an improving economy (read more here) and continued low interest rates, there are several reasons the market has room to go higher:

1. Fundamentals

Rising stock prices have been backed up by improving fundamentals. Based on historic levels and future earnings projections, we are not overvalued.

The chart below shows the trailing 12-month price-to-earnings (P/E) ratio of the S&P 500 over the past 50 years compared to its historic average (red line) and median (green line). In 1999, the price-to-earnings (P/E) ratio of the S&P 500 was over 30. Today, the P/E ratio is under 20 - in line with long-term historic levels.

(click to enlarge)

According to Yardeni Research, the market cap weighted average of consensus estimates for next year projects S&P 500 earnings will be $120.20 (see chart below), making the forward P/E ratio of the S&P 500 14.7.

(click to enlarge)

2. Strong Market

The bull market has not been a push straight up. It has been very orderly. The market has moved higher until bad news has come up, which has caused several corrections. After the bad news clears up, the market has kept going up before another round of worries and the cycle repeats.

The market has been through fears of a collapsing Euro, slowing growth in China, major employment issues, deflationary concerns, sequestration, a government shutdown, and less-than-optimal economic growth. Each worry gave an opportunity for those bearish on the market to get out, which has left more buyers than sellers. The result has been a very orderly and strong bull market.

3. Leading, not Lagging

Before 2001, stock market prices led fundamentals. In other words, prices were discounted based upon future expectations for earnings and dividend growth. Since then, fundamentals have been leading market prices. In the summer of 2002, we coined the term "show-me-the-money" to describe how the market seemed to be treating future earnings growth. Investors weren't willing to pay for earnings until they actually saw them.

In 2013, we have finally seen a return back to more "normal" stock market behavior where prices are reflective of future growth in fundamentals. This has shown up particularly in more cyclical sectors such as Industrials and Consumer Discretionary.

4. Dividends + Dividend Growth

As we have said many times, we believe the dividend is the best indicator of fundamental value. Not only have they represented 50% of total return, dividend growth over the last 50 years has been highly correlated with price growth. The most convincing argument to us is a simple valuation model that we have used for many years.

Take the current yield of the Dow Jones (2.5%) and add the projected 3-5 year dividend growth, which is roughly 9.5%. Compare that to the yield on a 30-year U.S. Treasury bond. When we do this, we find that 2.5% + 9.5% gives a total dividends and growth value of 12% compared to a Treasury yielding 3.60%.

The 50-year average dividend yield is 3.5% + 5.5% historical dividend growth for a total of 9%. The 30-year Treasury has averaged right at 5%. The long-term historical difference is that dividend yield + dividend growth has exceeded 30-year Treasury bonds by 4%, on average. The current spread of 8.4% is double the historic average and among the widest spreads of the past 50 years.

While dividend yields and dividend growth have returned to more normal levels, the fact is that they still represent a great value when compared to today's extremely low interest rates. It is for this reason that we believe stocks will continue to move higher until interest rates move up significantly or dividend growth would slow or some combination of the two. With the Fed saying rates will stay low, it's hard to believe bonds will change dramatically over the next couple of years. Based on the corporate forecast for earnings and dividend growth, we find it difficult to believe that current favorable business trends will evaporate. In that environment, we say stocks are likely to rise.

Source: Is The Market Overvalued?