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The stock market is vastly overvalued. While much has been made over the last few weeks about the current market correction, it’s merely a scratch on the surface when put into perspective. Sure we’re down 8%, but we’re still above the levels from just a few months ago in mid March. And we’re still positive for the year and 4% above the market peak at the end of QE1. From a historical view, the market is well above where it should be at this stage of the current secular cycle. And things could get very unpleasant for stocks if the underlying forces supporting the market were to suddenly fall away.

Stocks are currently overvalued by 34%. This is according to the 10-year price-to-earnings ratio data provided by Robert Shiller from Yale University. The 10-year moving average methodology is used in order to smooth out any short-term volatility in the earnings data. While it certainly has its limitations when viewing the market in a cyclical (short-term) context, it has great application when considering the market from a secular (long-term) perspective. What the Shiller data tells us is that there is a lot of air under the market right now.

Sometimes it makes sense for stocks to be overvalued. For example, if the economy is experiencing strong sustainable growth, investors are likely to be willing to pay more for a dollar of earnings in such an environment. Strong and sustainable growth has certainly not been the economy we’ve had over the last decade, however. Instead, we’ve seen various fits and starts including the bursting of a technology bubble, the collapse of the housing market and the financial crisis.

So what accounts for the overvaluation we’ve seen over the last decade? Put simply – leverage. Once the tech bubble burst in 2000, the financial system received the support of exceptionally low interest rates and the relaxation of the net capital rule that allowed investment banks to dramatically increase leverage. And when this excess leverage nearly collapsed the financial system in 2008, unprecedented fiscal spending and monetary stimulus from the U.S. government replaced it. So for the last decade, financial markets have been hopped up on one form of leverage or another all along the way.

So what happens if this support were to finally go away? Or, what if the mechanisms to provide this continued support are no longer able to do so? History provides us with a good idea. Markets have historically moved in secular cycles lasting roughly 16 years on average. For example, the stock market enjoyed secular bull markets from 1920-1929, 1946-1966 and 1982-2000. And the stock market has endured secular bear markets from 1900-1920, 1929-1946 and 1966-1982. Since 2000, we have been in a secular bear market.

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During secular bull markets, we have seen stocks move to valuation levels well above their historical average as would be expected. And during secular bear markets, we have seen stock valuations fall well below their historical average. This has been due to a variety of factors over these time periods, but can be boiled down to two factors – economic weakness and price instability (inflation and/or deflation) – both of which cause investors to be willing to pay far less for each dollar of earnings due to the associated uncertainty.

During the past three secular bear markets, stock valuations fell to levels well below their historical average. The typical range is anywhere between 6x to 12x historical 10-year earnings for an extended period lasting many years. During the current secular bear market, we briefly touched the 13x earnings level at the March 2009 lows for just a moment before quickly returning to the stratosphere. Thus, we have yet to see any true and sustained correction in financial markets during this current secular bear phase, which may be problematic.

A valuation wash out has always occurred during past secular bear markets. When the economy and markets finally cleanse the excesses that are at the root of the imbalances driving the secular bear period, it is only at this point that the market can finally bottom and a new secular bull market can begin.

Eleven years into the current secular bear market, we are long overdue to allow the system to cleanse itself. We are in the current economic situation because of too much leverage. The system must be allowed to go through a deleveraging process to properly heal. By piling more debt onto the system, first from the private sector and now from the public sector, it has served to not only prolong the cleansing process but is also leading to imbalances that have created new problems down the road. I fear we may be at such a crossroads in the current market.

Frankly, the stock market has no business trading at 22x trailing 10-year earnings with all of its underlying problems. The almost exclusive reason it is where it is today is because of QE2. And if QE2 is not replaced by QE3 in the next few months, or if an unwinding in the eurozone overwhelms even the best efforts from global policy makers, the market may finally lose its artificial support and finally deflate lower to valuation levels consistent with past secular bear episodes.

So what would these lower valuation levels imply for the stock market?

A move back to fair value at the 10-year historical average price-to-earnings ratio of 16.4 would imply the S&P 500 trading at around the 950 range. This is -25% below current levels.

A move to the high end of the valuation range during secular bear markets at 12x earnings would have the S&P 500 currently trading at roughly 700, which is -45% below where it is right now.

Lastly, a move to the low end (gasp) of the secular bear market valuation range at 6x earnings would imply the S&P 500 falling toward 350 (gasp again), which is over -70% below today’s close.

One last point. Every major bear market over the last century has not ended without a retest of its lows. Sometimes the retest occurred right away within a few months (2002). In other instances it took several years (1938 bottom retested in 1942). Many retests occurred on a nominal basis. Some retests occurred on a real basis (1982).

In today’s market, the March 2009 lows have yet to be retested. The market simply moving to valuations consistent with the advanced stages of a secular bear phase may be all that is needed to complete the retest and the final cleansing of the market necessary to then work toward the beginning of the next bull phase.

With all of this being said, the market may prove that it’s different this time. Perhaps stocks will continue to trade at current levels or even higher. And perhaps a new round of stimulus will extend the party for a few more years. But what this valuation analysis shows is the risks associated with the market at current levels. And if it turns out that it’s not different this time, it could be a sharp and unexpected move lower that brings the market to where history says it ought to be.

Stay tuned. The probability for QE3 and the ongoing situation in the eurozone will be the two keys to watch in helping to determine how it all plays out.

This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Stock Correction May Have Much Further to Go