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With the stock market in general, and small-caps in particular, having risen so briskly since the March 2009 bottom, it’s easy to talk about bubbles, overextended markets, and so forth. The evidence, however, does not seem to support the naysayers.

First things first. The fact that a market has risen over a certain amount of time and/or by a certain amount without a serous “correction” does not – I repeat, does NOT – mean it’s overextended. Context is crucial. It’s one thing for a strong rally to occur off a relatively high base. It’s quite another when the rally follows the sort of epic collapse we experienced in 2008. In fact, I’m not even sure we can even really call the past year’s price action a “rally;” the correct word may be “recovery.”

So much for touchy-feely. Now, let’s look at some evidence.

There are many ways to evaluate the reasonableness of stock prices, with P/E probably being as widely used as anything. But I’m a bit leery about using plain vanilla P/E right now. Unusual items (gains and charges) always have the potential to distort but now, having just come through a nasty recession plagued with bigger-than-usual and more-frequent-than-usual writeoffs, P/E is especially hard to use.

I’m going to relate price to something different, something I call Business Income. It’s Operating Income (or EBIT) excluding unusual gains and losses.

Using the historical screening capability of Portfolio123.com, I created Table 1, which shows median Price-to-Business Income ratios for all domestic stocks as of this writing (4/28/10) and back each year to 4/28/02. I even include negative ratios where Business Income was in the red.

Table 1

As of . . .

Median Price to Business Income

4/28/02

0.11

4/28/03

3.33

4/28/04

7.71

4/28/05

8.28

4/28/06

8.84

4/28/07

8.48

4/28/08

5.56

4/28/09

1.15

4/28/10

4.38

I got riled on this topic after reading a Seeking Alpha article by Graham Summers entitled The Small-Cap Bubble Is Ready to Burst: Part 1, which argued that the market is overextended just because it rose a lot. Given the small-cap thrust of that piece, it seems reasonable for me to look specifically at that segment of the market as well. Table 2 does that by focusing on companies with market capitalizations between $10 million and $1 billion.

Table 2

As of . . .

Median Price to Business Income

4/28/02

2.26

4/28/03

3.98

4/28/04

6.81

4/28/05

7.46

4/28/06

9.53

4/28/07

5.88

4/28/08

4.01

4/28/09

1.83

4/28/10

1.50

So where’s the bubble?

If anything, it looks like small caps still have more room to run relative to the market as a whole. Sure the Russell 2000 has been on a tear. But considering the depths to which small-cap prices had previously fallen, and the ongoing recovery in company bottom lines (not surprising since heavier operating leverage, the burden of fixed costs, which hurts small firms so badly on the way down gives them an added boost on the way up), we cannot conclude from the recent price strength that they’ve run out of steam.

This is certainly not the last word on the topic. I haven’t yet run price ratios using book value, sales, or even a measure of income that includes interest expense. If anyone wants to jump ahead of me and do the crunching, go for it.

Whatever the ultimate answer, this, as opposed to a no-context glance at recent price uptrends, is the way to assess whether or not a market is overextended. Based on the data presented here, it looks like a case for overextension could have been made back in mid-2006 even before the financial system and the economy started to sputter. Clearly, in early 2009, stocks were begging to be bought.

If the economy continues to improve, stocks in general and small-caps in particular still appear to have room to rise. Our situation today seems at least somewhat similar to 2003, another time when recent crisis dominated the investment community’s collective memory, when naysayers were regularly lambasting the bulls, and when, in retrospect, it turned out to still be a pretty good time to buy.

Disclosure: Author owns various micro-caps

Source: Don't Be So Quick to Assume the Market Is Overextended