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Dr. Kris has two degrees from MIT because one just wasn't enough. Her life goal was to figure out the universe and having done that (at least to her satisfaction), she decided to tackle something even more difficult—the stock market. Applying the scientific method along with an insatiably... More
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  • Market Notes: Is The Market Overvalued Or Undervalued? -- July 18 0 comments
    Jul 18, 2013 5:27 PM | about stocks: KBE, KRE, XLF, XLK

    Woo-hoo! The bulls took control today as the market-leading Dow Transport Index (DTX) zoomed up over 1.6% to a new all-time high. Not only that, but the Dow Industrial Index (DJIA) finally managed to blow through 15500, a level that has been a major source of overhead resistance for the past week. Not only did gentle Ben's soothing words comfort Congress as well as Wall Street, but the fact that second quarter earnings growth is on track to expand by 4-5% helped fan the rally's flames.

    Taking the lead today were the financials (NYSEARCA:XLF) and banks (KBE, KRE) all of which continue to inch to new highs. One of the few industry groups not invited to today's love-fest was the semiconductors (SMH, SOXX)which dragged on both the technology sector (NYSEARCA:XLK) and the tech-heavy Nasdaq.

    Is the market overvalued or undervalued?
    The question now is whether the next leg up in this rally has staying power. To determine that, we need to update our valuation metrics. Historical measures of the Price to Earnings (P/E) ratio on the S&P500 (SPX) are 15.5 as the median value and 14.5 as the mean value. These figures are based on trailing twelve month earnings. Assuming a trailing earnings scheme, the current P/E for the SPX is 19.53 (see this source). If we are to assume this metric, then the market is already overvalued.

    However, if we apply a forward P/E we will get a different result. This source gives the current forward P/E on the S&P as 14.3, clearly undervalued. The source also cites 117.8 as the current forward earnings number on the SPX. Using this value and applying the above median and mean historical P/E values (which may not be the correct thing to do) gives target values of 1708 and 1826 respectively. Depending on your point of view (and not being an economist I don't have one), the market is either overvalued at current levels or undervalued by as much as 8%.

    If you're as uncertain as I am, one way to play this is to cash out of long positions (either fully or partially) and replace them with options. This will raise cash but will also keep you in the game. Since volatility is very low, options are cheap--another bonus. Just my two cents.

    Subscriber Notes: There is one new Channeling Stock.

    Themes: long ideas, risk management Stocks: KBE, KRE, XLF, XLK
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