How Overvalued Is The S&P 500?

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by: Jonathan Weber
Summary

S&P 500 trades at all time highs.

Bank of America has collated 20 metric, 15 of those indicate an overvaluation.

Some of these metrics are impacted by outside factors and are thus not really useful to determine an overvaluation.

The S&P 500 (NYSEARCA:SPY) index, the most widely used index to gauge the strength as well as the overall valuation of the US stock market, has been hitting a couple of new highs over the last year. According to many metrics the index could be overvalued, or is, at least, trading at a premium relative to how the index was valued in the past.

The SPDR S&P 500 Trust ETF, which reflects the S&P 500 index at one tenth the price, has risen about 100% over the last five years, with a return of more than 25% over the last one and a half years. It is trading just below the all time high hit earlier this year.

To determine whether the S&P 500 is overvalued or not, we can look at 20 metrics which should help indicate that:

This table shows that most metrics indicate a higher valuation than what the S&P 500 usually was trading at, i.e. the index is more expensive than it used to be in the past.

The metrics with a blue frame in the third from the right are those that are higher than the historic average -- we see that this is true for fifteen of the 20 metrics Bank of America has looked at.

Let's take a closer look at some of them:

The S&P 500's current price to free cash flow multiple is below average, at 25.1 versus 28.4 historically, this indicates a rather low valuation versus the historic norm. Why is the price to free cash flow multiple much lower in comparison to the past, whilst the price to operating cash flow ratio is higher than it used to be? The reason is pretty simple, companies are spending a smaller percentage of their operating cash flows on capital expenditures in comparison to how much they allocated for capex in the past -- this is partially due to our economy shifting from a production heavy one to a more service based economy over the last decades, which results in less capital expenditures being needed -- there aren't many steel plants or railroad tracks being built any longer. At the same time companies have become more reluctant to invest heavily into production, even if there is demand, but are outsourcing capital intensive production to other companies (oftentimes in other countries): Apple, which is not manufacturing its smartphones, but focuses on developing and selling them, is a prime example.

There are thus good reasons for capex being lower right now than they were in the past, and this will likely remain the case going forward, the comparison of the current price / FCF ratio to where that ratio was in the past is thus not very informative.

Next we can look at the ratio of the S&P 500 price to the price of one barrel of oil (WTI): That ratio stands at 48 right now, which is more than twice as high as the historic average. The indication of a 105% overvaluation over the historic average is not very informative, however, as this ratio heavily depends on the price of oil, which can fluctuate heavily:

WTI Crude Oil Spot Price Chart

WTI Crude Oil Spot Price data by YCharts

As oil prices are down a lot over the last years, the current high ratio of that metric isn't very useful in indicating a (supposed) overvaluation of the S&P 500 index -- if oil was trading at prices it was trading at three years ago, the same metric would indicate an undervaluation with the S&P 500 index standing at 2400 points.

US Monthly GDP Chart

US Monthly GDP data by YCharts

Another metric that indicates a big overvaluation is the S&P 500 market capitalization relative to the GDP of the United States. That metric stands at 1.07 right now, which is 85% higher than what it used to be in the past. Yet it seems pretty clear that the S&P 500 index isn't overvalued by 85% for sure, the reason for a big move in that metric over the past decades thus has to be something else:

One of those factors is that companies in the S&P 500 index are generating a higher amount of revenues as well as earnings outside of the US (in comparison to that portion of total sales in past decades), those increase the value of the company, but not necessarily the GDP of the United States -- the metric thus increases over time.

Another factor is that profit margins of the corporate sector have increased over the last decades, if a higher portion of GDP ends up as net income in the income statements of the S&P 500 members, it is not surprising that the worth of these S&P 500 index increases relative to the size of the GDP.

The 85% increase in that metric is thus not really reflective of the actual (supposed) overvaluation of the S&P 500 index.

Takeaway

15 of the 20 metrics that Bank of America is using to determine an over- or undervaluation of the S&P 500 index are indicating that the valuation is higher than it used to be, but some of those metrics are not very useful to determine how much investors should pay for the index (or rather, its members). Overall it nevertheless looks like the S&P 500 index is rather expensive right now, investors thus shouldn't be too euphoric when employing new capital into the market.

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Disclosure: I/we 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.