Stock Market Valuation

I update market valuations on a monthly basis. I use six metrics to conclude whether the market is overvalued or undervalued.

As always, I must mention that just because the market is over or undervalued does not mean that future returns will be high or low. From the mid to late 1990s the market was extremely overvalued and equities kept increasing year after year. However, as I note at the end of the article I expect low returns over the next ten years based on current valuations.

Below are six different market valuation metrics as of August 1st, 2010:

The current P/E TTM is 18,3 , which is higher than the TTM P/E of 17.2 from last month. The P/E TTM is currently slightly overvalued.

This data comes from my colleague Doug Short of dshort.com.

Based on this data the market is moderately overvalued. However I do not think this is a fair way of valuing the market when considering the significant decrease in earnings over the past year. To get an accurate picture of whether the market is fair valued based on P/E ratio it is more accurate to take several years of earnings.

Numbers from Previous Market lows:

Mar 2009 110.37

Mar 2003 27.92

Oct 1990 14.21

Nov 1987 14.45

Aug 1982 7.97

Oct 1974 7.68

Oct 1966 13.96

Oct 1957 12.67

Jun 1949 5.82

Apr 1942 7.69

Mar 1938 10.63

Feb 1933 14.92

July 1932 10.16

Aug 1921 14.02

Dec 1917 5.31

Oct 1914 14.27

Nov 1907 9.35

Nov 1903 11.67

Historic data courtesy of [www.multpl.com]

Current P/E 10 Year Average 20.05

The 10 year P/E ratio is currently 20.05. This is higher the measurement from my previous article of 18.3. This number is based on Robert Shiller's data evaluating the average inflation-adjusted earnings from the previous 10 years. Based on my colleague, Rob Bennett's market return calculator, the returns of the market should be as follows:

My colleague Doug Short thinks this numbers are a bit inaccurate, because the number I used as it does not include the past several months of earnings, nor revisions. Doug calculates P/E 10 at.

Mean: 16.37

Median: 15.74

Min: 4.78 (Dec 1920)

Max: 44.20 (Dec 1999)

Numbers from Previous Market lows:

Mar 2009 13.32

Mar 2003 21.32

Oct 1990 14.82

Nov1987 13.59

Aug 1982 6.64

Oct 1974 8.29

Oct 1966 18.83

Oct 1957 14.15

June 1949 9.07

April 1942 8.54

Mar 1938 12.38

Feb 1933 7.83

July 1932 5.84

Aug 1921 5.16

Dec 1917 6.41

Oct 1914 10.61

Nov 1907 10.59

Nov 1903 16.04

Data and chart courtesy of [www.multpl.com]

This is moderately over valued from the average P/E as shown above.

Current P/BV 2.09

This is a very rough estimate, it is nearly impossible to get an exact number for P/B on a specific date to my knowledge.

The current P/BV is 2.09 , this is below P/B of 2.11 I measured in my previous article.

The average Price over book value of the S&P over the past 30 years has been 2.41. This indicates the market is slightly undervalued valued. Book value is considered a better measure of valuation than earnings by many investors including legendary investor Martin Whitman. He states that book value is harder to fudge than earnings. In addition book value is less affected by economic cycles than one year earnings are. P/BV therefore provides a longer term accurate picture of a company's value, than a TTM P/E.

Current Dividend Yield 1.99

The current dividend yield of the S&P is 1.99. This number is lower than the 2.13 yield from last month.

It is hard to determine on this basis whether the market is overpriced. The dividend yield for stocks was much higher in the begging of this century than the later half. The dividend yield on the S&P fell below the yield on Ten-Year treasuries for the first time in 1958. Many analysts at the time argued that the market was overpriced and the dividend yield should be higher than bond yields to compensate for stock market risk. For the next 50 years the dividend yield remained below the treasury yield and the market rallied significantly. In addition the dividend yield has been below 3% since the early 1990s. While I personally favor individual stocks with high dividend yields, I must admit that the current tax code makes it far favorable for companies to retain earnings than to pay out dividends. Finally, as I noted above the current economic environment has zero percent interest rates and low bond yields. During periods where yields are low it is logical for income oriented investors hungry for yield to be bid up the market, and dividend yields to decrease. I think it is hard to claim the market is overbought based on the low dividend yield.

Mean: 4.36%

Median: 4.30%

Min: 1.11% (Aug 2000)

Max: 13.84% (Jun 1932)

Numbers from Previous Market lows:

Mar 2009 3.60

Mar 2003 1.92

Oct 1990 3.88

Nov1987 3.58

Aug 1982 6.24

Oct 1974 5.17

Oct 1966 3.73

Oct 1957 4.29

Jun 1949 7.30

Apr 1942 8.67

Mar 1938 7.57

Feb 1933 7.84

July 1932 12.57

Aug 1921 7.44

Dec 1917 10.15

Oct 1914 5.60

Nov 1907 7.04

Nov 1903 5.57

Data and chart courtesy of [www.multpl.com]

Ratio = Total Market Cap / GDP	Valuatoin
Ratio< 50%	Significantly Undervalued
50%< Ratio< 75%	Modestly Undervalued
75%< Ratio< 90%	Fair Valued
90%< Ratio< 115%	Modestly Overvalued
Ratio > 115%	Significantly Overvalued
Where are we today (08/01/2010)?	Ratio = 78.7%, Fairly valued

The current level of is 78.7%, is higher than the 73.4% number from last month.

Stock Market Capitalization as a percentage of GDP is another metric albeit less commonly used than other metrics, to value the market. Between 75-90% market capitalization as percentage of GDP is considered fairly valued. Based on Guru Focus data the market should return about 6.5% per year based on the current value.

Warren Buffett has stated that market capitalization as a percentage of GNP is "probably the best single measure of where valuations stand at any given moment."

According to Barron's the ratio got as low as 40% in the late 1940s, when investors feared another depression, and in the inflationary 1970s.

Historic Data:

Min 35% in 1982

Max 148% in 2000.

Data and charts courtesy of Gurufocus.com

Current Tobin's Q 0.98

Tobins Q is 0.98 compared to 0.92 from last month.

The data comes from Doug Short. This is the most accurate data that is available. It is impossible for the data to be 100% precise because the Federal Reserve releases data related to Tobin's Q on a quarterly basis. The best that can be done is to extrapolate the data and try to provide the most accurate data possible based on the change in the Willshire 5000. This is what Doug did to get the current number. This method has proven extremely accurate for calculating Tobins Q on any given day.

The current level of 0.98 compares with the Tobins Q's average over several decades of data of approximately .72. This would show that the market is over valued.

According to Doug's estimates the market is over-valued by 39% based on Q's arithmetic mean..

In the past Tobin's Q has been a good indicator of future market movements. In 1920 the number was at a low of .30, the next nine years included phenomenal gains for the market. In 2000 Tobin's Q almost reached a record high of nearly 2, and the market declined subsequently about 50% by 2003.

Historic Tobins Q:

Market Low 1932 0.30

Market High 1929 1.06(this is not the highest number ever reached, just the number reached before the 1929 crash).

Average historic Tobins Q .72 (source: Stocks for the Long Run by Jeremy Siegel)

In the next monthly article I will have more Tobin's Q historical data.

To Recap

1. P/E(TTM)- slightly overvalued

2. P/E(10 year average)- Overvalued

3. P/BV- Slightly undervalued

4. Divdend Yield- Indeterminate/ undervalued

5. Market value relative to GDP- Fairly valued

6. Tobins Q- Overvalued

In conclusion the market is definitely not extremely over valued based on the above data. However, one can make the argument that the market is moderately overvalued. With the exception of P/BV, and market cap to GDP all the indicators point to at least a slightly overvalued market.

However the historical data fails to take into account current record low interest rates. I know not many investors take issue with my inclusion of interest rates in the equation. However, I think that most investors look at the stock/bond alternative. Right now you can get some blue chip stocks with dividend yields close to the Ten year treasury yield. I think with taking into account interest rates the market is fairly valued.

However, eventually the market will likely returns to normal valuation ratios as interest rates reach more normal levels. I believe returns over the next 10 years will be sub-par (below the 9.5% average market return). I think we will likely see returns of around that equal inflation over the coming decade.

You can read more about my predictions in the following two articles:

What Will The S&P 500 Return Over The Next 10 Years Part I

What Will The S&P 500 Return Over The Next 10 Years Part II

Disclosure: none

Note: I have received numerous suggestions on how to improve my monthly series. I tried to incorporate these ideas in my current article. Please email me or leave a comment if you would like to provide further suggestions.

Best Books on Market Valuations:

Valuing Wall Street : Protecting Wealth in Turbulent Markets by Andrew Smithers. The book explains in detail how tobin's Q is calculated.

Wall Street Revalued: Imperfect Markets and Inept Central Bankers. A more recent book by Andrew Smithers.

Irrational Exuberance By Robert Shiller. Great book by the man who calculates the P/E 10 ratio himself, Robert Shiller. The book is written in 2000, right before the tech bubble crash. Shiller correctly predicts the crash.