With Dow 12,000 suddenly the focal point of stock traders around the world, the question of whether or not stocks are overvalued seems to be cropping up with regularity. The thinking is that since the venerable DJIA has struggled for a couple days now at the latest big, round number, perhaps valuations are becoming a problem.
While the idea that stocks aren’t breaking on through to the other side of 12K due to valuation issues would seem to fly in the face of just about every Wall Street firm’s projections for 2011, Yale’s Robert Shiller thinks otherwise.
In an interview on CNBC Europe in Davos Switzerland Thursday, Shiller was asked what he thought about the U.S. stock market in terms of “fundamentals.” Although the question did seem to take the professor, who is also the developer of the Case-Shiller Home Price Index, by surprise, his response has been making headlines.
“I would say the market is overpriced based on fundamentals… I’m talking about the U.S. and probably Europe,” Shiller said.
Shiller went on to express concern that the bulls may not be able to vault the 12,000 level. “Dow 12,000 doesn’t stimulate me to excitement… I’m not sure we’ll get through it."
With the DJIA trading above the seemingly important (well, to the press, anyway) 12K level on both Wednesday and Thursday and yet failing to close above the key line in the sand (Thursday’s close was 11,989.83), Shiller’s argument looks to be okay for now. However, we decided to take a look at some of our favorite valuation models to see if Shiller has a point.
Anyone who has been in the game more than five minutes likely knows that the most oft-used version of stock market valuation is the price/earnings ratio. And while there are more than a handful of different ways to calculate this metric, the straightforward method takes, as you might suspect, the price of the S&P 500 divided by the forward projected earnings of the 500 stocks.
But since there is a lot of monkey business involved with “earnings” we prefer to look at the GAAP (Generally Accepted Accounting Principles) version. Based on values as of 12/31/10, it is interesting to note that the S&P 500 is almost dead on its 85-year average of 17. So, sorry Professor Shiller, there is no overvaluation seen here.
We can also look at “Operating Earnings,” which also show the S&P to be right at the average P/E since 1926 and actually at the low end of the range if viewed from the 1990’s. Then we can look at “Median P/E’s” which also shows the market to be fairly valued from 1969. And we can even take Shiller’s own “10-Year Average Earnings” model which shows the market to be only modestly above the average over the past 85+ years.
Another popular measure of valuation is Price-to-Book value. And based on the data we have from 1978, the market is just under the 33.1-year average. But to be fair, this data series clearly shows that the market’s valuation range changes over time. For example, in 1987, the current reading would have been considered very high. However, when compared to 2000, the current levels are quite low. So, this one is really not that helpful.
There is also the Price-to-Dividend ratio. Perhaps this is what Mr. Shiller is referencing because the current P/D is well above the historical norm. However, we should point out that companies have emphasized stock buybacks over dividend payments for many years now. Therefore, we will look at this particular measurement with at least a raised eyebrow.
Then there is the so-called “Fed model,” which incorporates the current level of interest rates into the mix. And while we can easily argue that interest rates have been kept artificially low for quite some time now, the bottom line is that stocks are very undervalued using this approach.
If the above exercise teaches us anything it is that valuation is definitely in the eyes of the beholder. The key is that when investors are feeling good, they will pay more for $1 of earnings on the S&P 500. And when they are fearful, they will simply decide to pay less.
So where does this leave us? Based on a lot of anecdotal evidence, it seems that the public is getting back into the stock groove (why not after a 90
%+ gain, right?). As such, we’ll be willing to bet that investors will be willing to pay up for earnings as they clamor to get back in. That is, right up until the time things get ugly, of course.
