A Simple Guide to Market Valuation (Hint - It's Overvalued)

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 |  Includes: IVV, SDS, SPY, SSO
by: Nicholas Cavallaro

When complexity confronts investors, apathy tends to take over. If a potential trade seems too ambiguous, avoidance altogether can be a prudent decision. But what happens to investors when the market itself becomes the trade? Languor and blind faith in the buy-and-hold strategy could prove harmful. When stocks abruptly drop, investors are surprised, upset, and fearful.

I believe the stock market is currently overvalued, and this is my guide to understanding the complex trade that most investors are in. Hear me out, and I’ll try to simplify this…

The stock market always bounces around. You’re not going to know if the market is going to go up or down tomorrow; there’s just too much random nature. However, over the course of a longer time period, say a year, investors generally have an idea that the market will stay within a certain range (gray).

So whether or not the market goes up or down, it will usually stay within this range.

So let’s take this little graph and expand it out to five years. Presumably, each subsequent year’s range would be incrementally higher than the previous year. Think about it, capitalism enables increases in the overall standard of living and increases the ongoing value of an economy; in turn, this value is reflected in the equity markets.

Given an increasing trading range, the market’s direction could look something like this:

When the price of the stock market trades within a reasonable range, the buy-and-hold method will work. An inexpensive ETF will adequately suffice. In this stock-picker’s market, superior stock picking skills (and perhaps some luck) are needed to beat other investors.

However, the reality is that the stock market doesn’t always neatly fit into my nice gray boxes on my graphs. Over the past five years, we know the market did this:

And relative to trading ranges, I believe the past five years looked something like this:

Similarly, since 1970, the market performed this way:

Which can also be displayed like this:

It is easy to see that the buy-and-hold strategy performed well for about 25 years until the tech bubble and housing bubble significantly inflated stock values.

Now, I don’t know if the current market situation will become the ‘Government Bubble’ or ‘US Dollar Bubble’ or if this will even be a ‘bubble’ at all, but I do think we’re outside of a normal trading range (gray boxes above), hence we’re overvalued here.

Reasonably thinking, how do we know the trading range?

Simple, the market can be thought of as a product of two factors: earnings and premium. Let’s start with earnings.

The companies that compose the S&P 500 (the market) had aggregate earnings of about $60 in 2009. Now, it is possible that earnings will improve in 2010. So if we apply the long term average earnings growth rate, the market will turn in about $64 for 2010.

But what if 2009 was an unusually depressed year, couldn’t earnings be higher?

Perhaps, so let’s look for an upper limit… In 2007, the market’s earnings were in the low $80s. This was a time period of heavy leverage and record profit margins. This scenario is unlikely to repeat, so $80 would be too high. Perhaps $70 is attainable, but $75 may be too high given the multiple tendencies for another recession to strike in 2010. Therefore, I can reasonably predict that earnings will be in the $60-$70 range for the market next year.

The premium paid for this $60-$70 of earnings depends on the implied return. Without getting into fancy jargon, think of it this way: people can expect their checking account to yield 0-1%, their savings account to yield 0-2%, and perhaps a tad more for a CD. An investor could expect a 5-6% return for a bond and 7-9% for stocks. To get a 7-9% return for stocks, investors would have to pay 11-14 times what expected earnings would be. (The inverse of 14 is 7.1%; the inverse of 11 is 9.1%).

So my factors are $60-$70 of earnings and 11-14x of premium. This gives me a lower trading bound of $660 ($60 x 11) and an upper trading bound of $980 ($70 x 14). This can be seen on a chart here. The $660 to $980 is my 'gray box' trading range. As of this writing (Jan 11, 2009), the market is priced at $1,145 (hence, I believe it is overvalued).

Now, before we go, there have to be some reasons as to why investors would bid the market up to where it currently stands. For starters, I would theorize that analysts still have record profit margins dialed into their forecasts (an idea I first read by William Hester at Hussman Funds); this is not sustainable. Second, there may be a fictitious belief that the Fed can reflate the economy, which on a long term basis is mathematically improbable; or that the Obama administration (or any administration) can create wealth, which is mathematically impossible (here is a related article). Finally, some investors may believe that the historical Price-to-Earnings ratio is closer to 16 than the 11-14 range suggested above; this is simply untrue and only implies a 6.25% return (not palatable given the risks involved).

Makes sense? Sounds right? Because like it or not, investors are in the trade. And since I view the market as overvalued, a buy-and-hold strategy could bring an unpleasant sting. There are a handful of alternatives, such as these, but investors need to make their own decisions. Don’t take the apathetic path either. Do something. Learn the trade, because you’re in it.

Disclosure: Short ITB, CYN, MRK; long SDS. The author has immediate family members who have positions that would benefit from a general market decline.