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With the market appearing to rollover and head lower, I thought it would be informative to take a look at our S&P 500 Fair Value calculation again. Its been a while since I’ve written about it, but with the annual “sell in May and go away” slogan being bantered about in the financial news and opinion articles/interviews now seems a good time to determine if the market is overvalued or undervalued at current levels.

As a refresher for long time readers of the blog, the calculation above takes four different metrics of the market based upon the historical mean valuation levels and computes a current value for the market using current data.

**1. Historic Mean P/E Ratio X Projected 2016 Earnings Estimates**

- Valuing the market based upon the underlying earnings of the companies computes a value based upon the returns that investors should expect to receive. Our calculation shows that the value of the S&P 500 under this metric is 1800 compared to our current value of 2058 [Market is Overvalued]

**2. Historic Mean Shiller P/E Ratio X Projected 2016 Earnings Estimates**

- This metric uses the same calculation above except it substitutes the Shiller P/E for traditional P/E. The Shiller P/E is calculated as a rolling 10-year average of the traditional P/E Ratio. The idea is to smooth out the volatility of any one year for a more representative valuation. Our calculation shows that the value of the S&P 500 under this metric is 1925 compared to our current value of 2058 [Market is Overvalued]

**3. Historic Mean Price to Book Value X Current Book Value**

- Price to Book Value is different from Price to Earnings in that P/E values the market by its earnings potential and P/B values it by the collective value of the assets of the companies in the market. Our calculation shows that the value of the S&P 500 under this metric is 2028 compared to our current value of 2058 [Market is Fairly Valued]

**4. Historic Mean Price to Sales Ratio X Current Sales**

- Price to Sales is different from either P/E or P/B in that P/S values a company according to its operational efficiency in generating revenue. Our calculation shows that the value of the S&P 500 under this metric is 1600 compared to our current value of 2058 [Market is Significantly Overvalued]

**The Final Step**

- To come up with an overall value, I use a weighted average of the above four calculations. To me, the two most important valuations are the Shiller P/E value and the P/S value because I prefer to have the smoothed earnings valuation that minimizes volatility and I prefer to look at a company’s ability to generate revenue over the value of its assets which by its very nature is a liquidation value for a company and not an ongoing business.
- Using the weighted average calculation on the chart above, you can see we come up with a Fair Value of 1823 for the S&P 500, or roughly 11% below the current value.

So how do we use this? I like to take a graphic look at the market to see what technical levels based upon investor sentiment tell us:

This graph tells me a lot about the market that supports the fair value calculation.

First, if you look at the horizontal line I’ve drawn at the bottom of the graph, it shows you where the market fell to on the February correction. That line corresponds fairly closely with our current Fair Value calculation. We should view that as a major support level for the market for two reasons:

- (1) its the prior correction low and it coincides with our fair value – this is the obvious one, and
- (2) if you look at the far left side of the graph you will see some red and green bars; these represent the volume of buyers and sellers at the various price levels; down at the 1823-ish level on the index you see a small red bar which indicates that level has primarily seen selling but not a lot of it which tells me most investors view that level as one to hold onto their investments because they are not being paid to sell and there is not any panic feeling about the market falling to that level.

In just the opposite reading, look at the second bar from the top. You see it is much larger than the bottom bar meaning there was a lot of trading volume at that level (which currently corresponds with the price level we are at now) and the bar is pretty closely split between green and red (with green slightly larger if you look really closely). This tells me that investors have no conviction at that price level for the index, the buyers will be likely sellers if the market doesn’t move up and the sellers will likely be buyers if it does.

So since the market has rolled over, the former buyers will on whole want to lock in the current price before the market goes down more, adding to downward pressure. Then as the selling gathers momentum, it should slow at the next level lower since there were fewer historic buyers. Interestingly enough, that level provides some additional technical support as both the 50-day moving average and the 200-day moving average are right there.

The market has the opportunity to turn higher at that level, between 2043 and 2013, however if it doesn’t, it will then likely head toward our 1823-ish horizontal support line. There will be other lesser support levels below 2013 and above 1823 which we can discuss if the market heads that way. However, you see the diminishing volume on the way down is predominantly green which means there are former buyers that will want to lock in their profits so they down show a loss, which will add to downward pressure on the index.

For now, though, my view is pretty bearish overall and view the market as headed lower. It is VERY significant that (1) corporate sales and earnings continue to fall putting more downward pressure on our Fair Value and (2) the market has been unable to break above the all time high set last May and from a technical standpoint it looks like in the near-term the market is headed lower and will not make an assault on that peak anytime soon.

Because of this, we have an overweight of cash and bonds in client portfolios in order to (1) protect their capital and (2) to give us ammunition to pull the trigger on buying some of our favorite companies at lower values.

As things progress, check back here or you can subscribe by clicking the link above and get an automated shout out via email when a new post is made.

Mark