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Is the Stock Market Overvalued?

SPX

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It has been eight years since the 2008 stock market crash bottomed and the current bull market began.  There have been a couple of corrections along the way, even a couple of double digit ones, but all in all it has been a fairly straight move up.

We can discuss some of the reasons for this, but it has been engineered to a large extent by the Federal Reserve and their money printing activities (called Quantitative Easing – a process of buying bonds with newly created money).  That liquidity has been used by corporate America to buy back shares of stock (as opposed to investing in research and development or expanding operations) which has pushed the market forward in a fairly consistent manner.  In its simplest from, its Supply and Demand – as long as corporate America has the demand to buy back their own stock and the supply of shares is limited to what people are willing to sell, there is always an upward pressure on stock prices.

The Federal Reserve has been raising interest rates for the past several months, which has begun to curtail liquidity.  However they are about to embark on a reversal of their money printing activities – possibly as soon as September.  In essence, they will be flooding the bond market with government bonds hoping to suck up excess cash that has been flowing into the stock market over the past eight years.  This process (called Quantitative Tightening) simply sells bonds into the market and the money they receive for them is retired from the system.

This is a really big deal and you are likely not hearing much about it.  But from a logic standpoint, if flooding the system with money led to the stock market going up due to a consistent buyer willing to pay market price for their own stock, then logically starving the system of money will remove the principal buyer of stock and send the market down.

How far?  Clearly since this is new territory for all of us, there is no way to know for sure.  But realistically, any over-valuation in the market will likely be erased and potentially, depending upon investors’ emotions, a correction could go further than that.

So I thought it was time to break out my trusty S&P 500 Fair Value Calculators to see what sort of exposure we might have.  Lets check out the Ratio Based version:

Fair Value Ratio

This version is based upon the theory that everything eventually reverts to the mean.  It compares current readings of the S&P 500 – like earnings, sales, and book value – to historic median valuation levels for the S&P 500.  This shows what the index would be valued at using current numbers but historically typical valuation levels.

This calculation uses a weighted average of the various ratios – in the graphic above, you can see that there are two calculations.  One of calculations is an outlier so the first column underweights that one with a 10% weight and the other one gives it 0% weight.   For simplicity sake, we will say that the ratio based analysis tells us that the S&P 500 is 13% to 15%  over-valued.

But lets take it one step further.  Below is a discounted earnings based valuation of the S&P 500.  The earnings estimate comes from Standard & Poors and is a bottom up GAAP estimate of all 500 companies in the index projected through 12/31/2018.  The growth rate is the actual 2017 growth rate and the discount rate is a calculated number based upon the historic S&P 500 return since 1950 + the rate of inflation + the increase in GDP (the calculation is shown as Discount Rate Two).   I have disregarded the alternate version of the discount rate calculation that is an interest rate based calculation ( shown as Discount Rate One) given the artificially low level of interest rates.

Fair Value Disctd Earnings

This discounted earnings calculation uses a ten year period of earnings growth at current rates and a an earnings growth rate of 2% into perpetuity.

Based upon the calculation, we show an over-valuation of over 7%, which is half the ratio based valuation result.

Which is correct?  Realistically you cannot look at it that way.  Each of the calculations could be changed with a different selection of data that would give higher or lower results.  The real benefit of this sort of calculation is to give us a feel for whether the market is over or under valued based upon some reasonable set of assumptions about the future using current data about the market.  We can reasonable say that the market is over-valued by 7% to 15% and that any correction we might have (in September or otherwise) would be within that range – and absent some other factor we are not considering, we should not have a crash like we had in 2008.

So, given the uncertainly in the market’s potential reaction to the Fed’s September Quantitative Tightening, I am comfortable with the conservative position we have in client portfolios with cash and short term bonds on hand.  That will give us liquidity to buy shares of our favorite companies a lower prices than currently available.  Until then we just need to have some patience…

and show some smarts.

–Mark