Are Stocks Overvalued Yet?

It's tough to be a bear these days.

At the beginning of the year, those seeing the glass as at least half-empty were expecting Europe (NYSE:EZU) to drag the economies of the world into recession, China's (NYSE:FXI) economic growth to tank, the unrest in the Middle East to become a huge problem, the Fed to make a mistake, earnings to soften and the politicians in Washington to send the U.S. into a depression.

In short, the bears were calling for the sky to fall and for the U.S. stock market to crash and burn.

The only problem with this thesis has been that Europe's economy is actually recovering, China's GDP continues to grow at around 7. 5 percent, the situation in Syria blew over quickly, Fed policy continues to be uber-friendly, corporate earnings for the S&P 500 (NYSE:SPY) are at record levels, and try as they might, the politicians haven't managed to blow up the Republic just yet.

Oh and for those keeping score at home, the S&P 500 is up 21.5 percent year-to-date and finished Friday at a fresh all-time high. So, the question to the bears is how is that negative macro view working out so far?

Bears Say Stocks Are Overvalued!

Despite being dead wrong on Europe, China, the U.S. economy, earnings and the how the market would perform in 2013, the bear camp remains largely undeterred. Instead of admitting defeat, the current battle cry is that stocks are overvalued and as such, will soon succumb to an episode of mean reversion akin to what was seen in 2000-02.

As Exhibit A in the argument, the negative Nancys of the world point to the long-term chart of the S&P 500. The argument is that with prices as high as they currently are, the only direction they can head from here is down.

S&P 500 Index - Monthly Since 1980

To be fair, the chart above does appear to be a bit extended. And yes, it is true that the S&P has moved up an awful long way since the credit-crisis low seen in March 2009 (161.5 percent to be exact). Therefore, the argument that stocks are overvalued would seem to make some sense on the surface.

However, The Indicators Suggest Otherwise

While the performance of the S&P has been impressive lately and the current run on the monthly chart does look like it could use a rest, the facts suggest that stocks are not overvalued at the present time.

The first thing to understand is that earnings are at record highs. As such, it isn't terribly surprising to see the indices at record highs as well.

Using GAAP (generally accepted accounting principles) numbers, which are far more reliable that the "operating earnings" companies love to report, the S&P 500 is expected to produce earnings of $98.28 in 2013. This is up from the $86.51 seen in 2012, the $77.35 in 2010, and the $69.93 EPS seen in 2005. And the expectations for 2013 are roughly double the GAAP EPS from 2000, which came in at $50.

The bulls will go so far as to suggest that since earnings are almost double where they were in 2000, stocks should be higher, perhaps much higher. However, it should be noted that the environment was quite different in 2000. At that time, P/E levels were extended as investors were falling all over themselves to buy stocks, which is definitely not the case at this point.

Valuations Are No Worse Than Average

To be sure, the valuation game can be tricky. However, if one compares apples to apples over a very long time period, the bottom line is that stock valuations are just a smidge above average right now.

Here are the details using GAAP earnings on the S&P 500:

Current Price-to-Earnings ratio: 17.80
50-Year Average P/E ratio: 19.20
25-Year Average P/E ratio: 24.86
87-Year Average P/E ratio: 16.98

So, it is safe to say that no matter what time-frame is chosen, the current P/E ratio of the S&P on a GAAP basis is not overvalued.

Where Would the S&P Be Overvalued?

Based on data going back to 1926, the GAAP P/E ratio would have to be above 20.2 in order to be considered "expensive". Thus, the S&P would need to move above 1985 this year to reach the overvalued zone. For the record, that means the index could rise another 13.8 percent from Friday's close before being considered expensive.

What about next year? While projecting earnings can be a tricky business, GAAP EPS is estimated by Standard & Poor's to come in $108.29 in 2014. Based on the 87-year average, a "fair value" price for the S&P 500 would be 1839. Based on the 50-year average P/E, fair value would be at 2079. And based on the past 25-year, the S&P's fair valuation would be 2692.

Thus, assuming that stocks continue to rise until "fair value" is reached, the S&P could advance 5.4 percent from here through 2014 based on the 87-year average, 19.2 percent based on the 50-year average, and 54.3 percent if the 25-year average GAAP P/E is used.

Taking this exercise one step farther, the bears could claim that the market was overvalued if the S&P were to reach 2187 in 2014 (20.2 times $108.29), which represents an increase of 25.4 percent from Friday's close of 1744.50.

So... the bottom line is that while it may be painful for the bears to recognize, from an historical standpoint, stocks can indeed move higher from here based on valuations tied to earnings. Thus, if one is looking for a reason to be bearish, they'd best find a thesis that includes earnings falling instead of rising.

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Current Market Drivers

We strive to identify the driving forces behind the market action on a daily basis. The thinking is that if we can both identify and understand why stocks are doing what they are doing on a short-term basis; we are not likely to be surprised/blind-sided by a big move. Listed below are what we believe to be the driving forces of the current market (Listed in order of importance).

1. The State of the Earnings Season 2. The Outlook for the U.S. Economy 3. The State of Fed Policy

The State of the Trend

We believe it is important to analyze the market using multiple time-frames. We define short-term as 3 days to 3 weeks, intermediate-term as 3 weeks to 3 months, and long-term as 3 months or more. Below are our current ratings of the three primary trends:

Short-Term Trend: Positive (Chart below is S&P 500 daily over past 1 month)

Intermediate-Term Trend: Positive (Chart below is S&P 500 daily over past 6 months)

Long-Term Trend: Positive (Chart below is S&P 500 daily over past 12 months)

Key Technical Areas:

Traders as well as computerized algorithms are generally keenly aware of the important technical levels on the charts from a short-term basis. Below are the levels we deem important to watch today:

Near-Term Support Zone(s) for S&P 500: 1720-25
Near-Term Resistance Zone(s): none

The State of the Tape

Momentum indicators are designed to tell us about the technical health of a trend - I.E. if there is any "oomph" behind the move. Below are a handful of our favorite indicators relating to the market's "mo"...

Trend and Breadth Confirmation Indicator: Positive
Price Thrust Indicator:Positive
Volume Thrust Indicator:Neutral
Breadth Thrust Indicator:Positive
Bull/Bear Volume Relationship: Moderately Positive
Technical Health of 100 Industry Groups: Positive

The Early Warning Indicators

Markets travel in cycles. Thus we must constantly be on the lookout for changes in the direction of the trend. Looking at market sentiment and the overbought/sold conditions can provide "early warning signs" that a trend change may be near.

Overbought/Oversold Condition: The S&P 500 is overbought from a short-term perspective and is moderately overbought from an intermediate-term point of view.
Market Sentiment: Our primary sentiment model is neutral .

The State of the Market Environment

One of the keys to long-term success in the stock market is stay in tune with the market's "big picture" environment in terms of risk versus reward because different market environments require different investing strategies. To help us identify the current environment, we look to our longer-term State of the Markets Model. This model is designed to tell us when risk factors are high, low, or uncertain. In short, this longer-term oriented, weekly model tells us whether the odds favor the bulls, bears, or neither team.

Weekly State of the Market Model Reading: Positive

If you are looking for a disciplined, rules-based system to help guide your market exposure, check out The Daily Decision System.

Thought For The Day...

We cannot become what we need to be by remaining what we are. -Max De Pree

Looking for Guidance in the Markets?

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Mission Statement

At StateoftheMarkets.com, our goal is to provide everything you need to be a more successful investor: The must-read headlines, market commentary, market research, stock analysis, proprietary risk management models, and most importantly actionable portfolios with live trade alerts.

Finally, we are here to help - so don't hesitate to call with questions, comments, or ideas at 1-877-440-9464.

Wishing you green screens and all the best for a great day,

David D. Moenning Founder and Chief Investment Strategist StateoftheMarkets.com

For up to the minute updates on the market's driving forces, Follow Me on Twitter: @StateDave (Twitter is the new Ticker Tape)

Positions in stocks mentioned: none

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