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Stock Market Records Vs Valuation


The year-to-date performance of the stock market has been characterized in many ways in the media. I’ve heard it called: a low volume melt-up, a record-setting market, just a stop on the way to DOW 20,000, and more.

There is no doubt that the stock market has moved higher this year – and we have kept our clients fully invested along the way to take advantage of it. There is, however, that pesky issue of valuation that keeps me on edge.

By many traditional measures, the stock market is overvalued:
· On our blog, we have posted the graph of the Shiller P/E 10, a version of the Price-to-Earnings Ratio that is the S&P 500 Index price divided by the average earnings from the previous 10 years – the 10 year time period is designed to smooth out volatility in the data. Today, we are at the third highest valuation ever for this indicator, only surpassed by the valuation on Black Tuesday of the 1929 stock market crash and the valuation in 2000 right before the NASDAQ stock market crash.


· If we look at the traditional P/E Ratio, it is currently approaching 20, a level widely accepted as overvalued. Following is a graph that shows you how the P/E Ratio has moved over the past 20 years – with annotations drawn in for undervalued (a P/E of 10), fairly valued (a P/E of 15) and overvalued (a P/E of 20).


· The Fed Model is relational graphic that shows you where the Forward Earnings Yield on the S&P 500 is in relation to the 10-year Treasury Note Yield. From this relationship, a Risk Premium is determined. When the Risk Premium is rising, investors are being better compensated for assuming the risk of investing in the stock market over risk free treasury bonds. At the current time, however, the risk premium is falling (the black line on the graph below) and investors are being less adequately compensated than in the recent past as the S&P 500 continues its rise (the blue line on the graph below).


· The component parts of the Fed Model are also instructive to review. When the earnings yield of the S&P 500 is increasing relative to the yield on the 10-year Treasury Note, there is increasing value for investors in the stock market. At the current time, margin between the earnings yield (the purple line on the graph below) and the treasury yield (the green line on the graph below) is narrowing.


Based upon these items, valuation in the stock market is stretched. The last major correction was in the summer of 2011 where the market fell 18%. We have not even had a pull back to the 200-day moving average since November 2012. So some caution is warranted, in my opinion.

However, as long as the Federal Reserve continues to provide excess liquidity to the US economy through its accommodative monetary policy actions, that will provide support for the stock market and investors will likely continue to push the stock market higher – albeit with some natural bumps in the road which most still use as a “buy the dip” opportunity.

At some point, though, valuation will matter again. When will that be? Either when the Federal Reserve changes its current accommodative policy or when investors perceive it is about to make the change.

For now, though, we are staying fully invested and riding the trend until there is evidence that the trend is no longer our friend.