Stock Market Valuation In One Simple Chart

Includes: IVV, SPY, VOO
by: Paul Price

In order to study medicine you must first learn Histology - the study of normal tissue, before mastering Pathology - the study of abnormal tissue (disease). You simply cannot recognize abnormal unless you know what normal looks like.

Evaluating the stock market requires similar skills. For humans, possessing a 'normal' body is a good thing. Owning stocks in a normalized valuation environment, though, gives you no systemic edge. The hardest time to predict future price trends is when the overall market is neither cheap nor expensive.

Where does today's valuation fall in the big scheme of things? How can we tell?

I've done the legwork so you don't have to. The chart below shows the S&P 500 from 1994 through the end of August 2012. I've highlighted the best three buying opportunities in recent years with green stars. The two screaming tops are marked with red stars. Last week's close is shown in yellow.

What jumped out to me were the yields at those 'should-have-been-buying' inflection points; 2.72% at 1994's low, 2.03% following 2001's recession and an astoundingly good 4.21% at the March 2009 panic bottom, in the midst of the 2008-09 recession.

P/Es at the three low points varied from 10.2x to 17.1x trailing earnings. The somewhat higher number in 2002 was more the result of recession-reduced 2001 earnings more than high forward expectations. The P went down but the E dropped even further.

Those 'needed-to-have-been-selling' moments in 2000 and 2007 showed much lower than typical yields of 1.32% and 1.74%. Yields that low should have been enough of a warning signal all by themselves.

A glance at the trailing P/E of 34x in 2000, versus 1994's sub-14 multiple was screaming "SELL". 2007's top P/E of almost 19 was a bit higher than normal even if the economy was going to continue booming. As things played out, S&P 500 EPS topped out at $87.72 in 2006. They then dropped sequentially to $82.54 and $65.35 in 2007 and 2008. The final trough came with full year S&P 500 EPS of $60.80 in 2009.

At last week's closing price of 14,124 the S&P 500 was at 15.94x trailing and about 13.4x expected 2012 EPS of $105.31. Unless you think estimates are too high the broad market looks somewhat undervalued based on P/E.

The current yield for the S&P 500 is 1.94%. That would place today's index pretty squarely in neutral territory by historical standards. Artificially low, ZIRP-induced fixed income rates, now provide weaker than typical competition for investment capital. In 2006 you could still buy 6% - 7% CDs and T-notes.

That makes 1.94% look fairly attractive rather than pedestrian.

I'd give the market a slightly bullish bias right now based on its present and forward P/Es. The current dividend rate, taking into account the state of the fixed income market, is decent, but not compelling. It's likely to be a rewarding time for good stock selection as opposed to simply index trading.

There's a reason this site is called Seeking Alpha.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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