Market Overvaluation Hitting Critical Levels

 |  Includes: DIA, IVV, IWB, IWM, IWV, QQQ, SPY, VOO
by: Steve Hach

Valuation Warning: Our models find that overvaluation is approaching levels typically seen when a market correction is imminent. Overvalued stocks now make up 65% of our universe and more than 33% of the universe is calculated to be overvalued by 20% or more. Fifteen of 16 sectors are now calculated to be overvalued.

Our ValuEngine Valuation Model tracks more than 5,500 U.S. equities, ADRs, and foreign stocks that trade on U.S. exchanges. The model calculates a level of mispricing or valuation percentage for each equity based on what the stock should be worth if the market were totally rational and efficient -- an academic exercise, to be sure, but one which allows for useful comparisons between equities, sectors, and industries.

We track valuation figures and use them as a metric for making calls about the overall state of the market. As of last night's close, our "overall market overvaluation and overvalued by 20% or more" figures have reached levels strongly correlated with market corrections in the past.

Whenever we see levels in overvaluation levels in excess of @ 65% for the overall universe and 30% for the overvalued by 20% or more categories, we issue a valuation warning. We issued a market valuation watch on December 15; since then the market has continued to climb and our models have only increased the levels of calculated overvaluation.

Based on the latest model calculations, we have issued a market valuation warning. We reiterate again that this is a time for investors to keep a close eye on the market, tighten their stop losses, book some profits, and hedge against a move to the downside.

This chart shows overall universe valuation in excess of 60% vs the S&P 500 from the end of March 2010 to the present:

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This chart shows universe overvalued by 20% or more levels in excess of 27% vs the S&P 500 from the end of March 2010 to the present:

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In addition to the overall valuation metrics, we see that on a sector basis 15 of 16 sectors are calculated to be overvalued. As you can see from the chart below, the level of overvaluation for many sectors has also increased since we issued our valuation watch December 15.

Sector 12/15/2010 1/6/2011
Aerospace 7.51% overvalued 11.69% overvalued
Auto-Tires-Trucks 14.28% overvalued 18.77% overvalued
Basic Materials 29.55% overvalued 33.10% overvalued
Business Services 6.52% overvalued 9.35% overvalued
Computer and Technology 7.22% overvalued 11.86% overvalued
Construction 5.94% overvalued 9.12% overvalued
Consumer Discretionary 6.24% overvalued 8.61% overvalued
Consumer Staples 11.45% overvalued 12.36% overvalued
Finance 7.25% overvalued 10.66% overvalued
Industrial Products 15.30% overvalued 18.73% overvalued
Medical 5.48% undervalued 1.36% undervalued
Multi-Sector Conglomerates 14.70% overvalued 18.52% overvalued
Oils-Energy 22.95% overvalued 29.29% overvalued
Retail-Wholesale 9.36% overvalued 11.19% overvalued
Transportation 12.04% overvalued 15.97% overvalued
Utilities 8.23% overvalued 9.30% overvalued
SP 500 1241.59 1276.56
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In the past, our chief market strategist, Richard Suttmeier, has used the sector valuation figures to buttress his macro market calls. Almost 14 of the 16 sectors are calculated to be overvalued by 10% or more. This is another indicator that stocks are no longer the bargain they were a few months ago, and that investors should consider implementing additional risk management tools and/or booking some profits.

Of course, as always, past performance is no indication of future behavior. Given the wild gyrations of the markets over the past few years, it has been tough to rely completely on any fundamentally or technically-based mode of analysis. But as you can see from the charts below, the overvalued indicator has been fairly robust and thus must be considered as we move forward.

This chart shows universe overvaluation figures in excess of 60% vs the S&P 500 from 1991 up until the end of May 2010:

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This chart shows universe overvalued by 20% or more levels in excess of 30% vs the S&P 500 from 1991 up until today:

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As you can see from the charts, in many cases in the past the spikes in overvaluation - -particularly the "overvalued by 20% or more" metric -- provided a timely signal of an impending correction.

Our most recent valuation watch occurred in late April 2010, just as the market headed down for the summer.

Market Indices Data

Latest Change YTD
Dow Jones
11,679.40 -43.51 0.88%
NASDAQ Composite
2,704.65 2.45 1.95%
Russell 2000
793.12 -1.97 1.21%
S&P 500
1,272.14 -4.42 1.15%
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ValuEngine Market Overview

Summary of VE Stock Universe
Stocks Undervalued
Stocks Overvalued
Stocks Undervalued by 20%
Stocks Overvalued by 20%
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ValuEngine Sector Overview

Sector Change MTD YTD Valuation Last 12-MReturn P/E Ratio
Basic Materials 0.09% -1.47% -1.47% 33.10% overvalued 60.68% 37.70
Oils-Energy 0.88% 0.10% 0.10% 29.29% overvalued 32.09% 42.11
Auto-Tires-Trucks 1.92% 1.82% 1.82% 18.77% overvalued 46.38% 26.92
Industrial Products 0.35% -0.33% -0.33% 18.73% overvalued 29.54% 26.55
Multi-Sector Conglomerates 1.00% 0.31% 0.31% 18.52% overvalued 32.09% 30.38
Transportation 0.87% 0.29% 0.29% 15.97% overvalued 27.63% 42.98
Consumer Staples -0.08% -0.76% -0.76% 12.36% overvalued 16.55% 27.94
Computer and Technology 1.24% 7.29% 0.97% 11.86% overvalued 32.16% 44.68
Aerospace 1.06% 0.77% 0.77% 11.69% overvalued 32.73% 20.24
Retail-Wholesale 0.81% -0.50% -0.50% 11.19% overvalued 60.52% 22.28
Finance 0.92% 0.06% 0.06% 10.66% overvalued 19.26% 25.40
Business Services 1.22% 0.80% 0.80% 9.35% overvalued 19.57% 30.13
Utilities 0.15% -0.22% -0.22% 9.30% overvalued 12.52% 25.65
Construction 1.12% -0.32% -0.32% 9.12% overvalued 10.43% 38.56
Consumer Discretionary 1.18% 0.41% 0.41% 8.61% overvalued 24.16% 31.70
Medical 0.87% 0.50% 0.50% 1.36% undervalued 18.56% 37.85
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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.