Is the Stock Market Overvalued Right Now?

Is the Stock Market Overvalued Right Now? The Dow Jones and the S&P 500 have hit fresh all-time highs this year, and many investors are starting to consider whether stocks are approaching “overvalued” territory. As investors, you’ve worked hard to accumulate assets and grow your portfolio over time, so it’s natural to wonder if “being overvalued” could mean it’s time to pare back your equity holdings or at least reconsider your asset allocation.

But the real question to address first is: are stocks really overvalued? JP Morgan Research puts current stock valuations in perspective by taking a look at how they measure up historically. What they found is that current valuations are actually pretty close to their long-term averages, and not necessarily overvalued on a relative basis.

Stocks Valued In-Line with Historical Averages

In the “Forward P/E Ratio” chart below, you can see that during the late 1990’s valuations rose well above the average of 15.6x, and stocks continued to perform well during that time. In other words, just because stocks are trading close to historical averages in terms of valuations – or even if they drift a bit higher – does not automatically indicate that stock prices have hit a ceiling.

Stock Valuation Measures: S&P 500 Index

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Source: Standard & Poor s, FactSet, Robert Shiller Data, FRB, J.P. Morgan Asset Management. Price to Earnings is price divided by consensus analyst estimates of earnings per share for the next 12 months. Shiller’s P/E uses trailing 10-years of inflation adjusted earnings as reported by companies. Dividend Yield is calculated as the trailing 12- month average dividend divided by price. Price/Earnings to Growth Ratio is calculated as NTM P/E divided by NTM earnings growth. Price to Book Ratio is the price divided by book value per share. Price to Cash Flow is price divided by NTM cash flow. EY Minus Baa Yield is the forward earnings yield (consensus analyst estimates of EPS over the next 12 months divided by price) minus the Moody’s Baa seasoned corporate bond yield. *P/CF is a 20-year avg. due to cash flow data availability. Latest reflects data as of 6/30/14. Guide to the Markets – U.S. Data are as of 6/30/14.

“If you look just at a 12-month forward price-to-earnings, it's pretty much in line with the 20-year average. People seem to think it's high because it's risen a lot from very low levels, but it's not high by history." – Giles Keating, Deputy Global Chief Investment Officer for Private Banking, Credit Suisse.²

In addition, the “S&P 500 Earnings Yield vs. Baa Bond Yield” chart indicates that the earnings yield on stocks remains attractive relative to bond yields, meaning that investors could continue to favor stocks as an asset class relative to bonds or cash.

Healthy Corporations May Support Higher Valuations

JP Morgan Research does a sound job of painting the current picture for US corporate earnings and growth, both of which appear to be in solid shape now and looking forward. Profits and earnings are high and rising, and corporations are holding less debt relative to equity compared to their historical averages:

Corporate Profits and Leverage

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Source: BEA, Standard & Poor’s, Compustat, J.P. Morgan Asset Management. EPS levels are based on operating earnings per share. *Most recently available data is 4Q13 as 1Q14 are Standard & Poor’s preliminary estimates. Past performance is not indicative of future returns. Guide to the Markets – U.S. Data are as of 6/30/14.

With extra cash on hand, corporations have the ability to increase their capital expenditures (the money they invest in production and equipment); to buy back shares; and/or, to increase the dividends they pay to shareholders – all positive forces for corporate growth and development which can lead to stock price appreciation as well.

Deploying Corporate Cash

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Source: Standard & Poor’s, FRB, Bloomberg, FactSet, J.P. Morgan Securities, J.P. Morgan Asset Management. (Top left) Standard & Poor’s, FactSet, J.P. Morgan Asset Management. (Top right) M&A activity is the quarterly value of deals completed and capital expenditures are for nonfarm nonfinancial corporate business. (Bottom left) Standard & Poor’s, FactSet, J.P. Morgan Asset Management. (Bottom right) Standard & Poor’s, Compustat, FactSet, J.P. Morgan Asset Management. Guide to the Markets – U.S. Data are as of 6/30/14.

A Realistic View of the Stock Market for 2014

2013 was a banner year for stocks, with the S&P 500 rising +30%.³ It makes sense that the following year could deliver more normalized returns, which is what we have seen so far in 2014 - through August 13, the S&P 500 is up +5.3% and the Dow Jones is up +0.5%.⁴

Stock performance in 2014 offers a good reminder, which is that the stock market goes through cycles and will not always power through to new highs each year. Even during bull market cycles, there are years when the market is flat or even slightly negative.

Past Stock Market Corrections and Declines

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Source: Standard & Poor’s, FactSet, J.P. Morgan Asset Management. Returns are based on price index only and do not include dividends. Intra-year drops refers to the largest market drops from a peak to a trough during the year. For illustrative purposes only. *Returns shown are calendar year returns from 1980 to 2013 excluding 2014 which is year-to-date. Guide to the Markets – U.S. Data are as of 6/30/14.

2011 is a good example – the market experienced a volatile year with a sizable stock market correction within it, and ultimately ended the year with flat returns.³ Whether or not 2014 ends up that way remains to be seen, but the important takeaway is to remember that stock market corrections of 10% or more in any given year is a fairly normal occurrence. Keep this in mind should some volatility start to set in later this year.

Is the Stock Market in a Long-Term Uptrend Pattern?

Taking an even higher level view of the market’s course over history gives us some insight as to what could be ahead. Looking back at the market since 1900, it becomes apparent that the market is in a sideways pattern that resembles past cycles, particularly 1937-1948 and 1966-1974.

Stock Market Since 1900 (S&P 500 Composite Index)

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Source: Robert Shiller, FactSet, J.P. Morgan Asset Management. Data shown in log scale to best illustrate long-term index patterns. Past performance is not indicative of future returns. Chart is for illustrative purposes only. Guide to the Markets – U.S. Data are as of 6/30/14.

Whether the market continues to bounce along sideways or breaks through into a long-term uptrend remains to be seen. Regular conversations with your Financial Advisor can help keep you up to speed so you know our outlook and how your portfolio is positioned accordingly.

Should You Make Any Changes Today?

With healthy corporate profits and stocks valued at close to historical averages, it is reasonable to believe that stocks could have more room to appreciate – though it could come with volatility along the way.

If you believe the stock market is overvalued, review your investment plan with your financial advisor. Also consider tactical money manager strategies, which are designed to participate in rising markets with the ability to fully move to cash should conditions turn bearish.

One such strategy is Newfound Research’s Risk Managed Global Sectors which is designed to participate in rising markets while also seeking to limit capital losses when the market declines. To learn more about Newfound’s strategies and how they might work for you, one of our Wealth Managers can send you information or speak with you on the phone to share details. You can also request the information here.

Beyond having a tactical money manager strategy in your portfolio, it is important to check your asset allocation relative to the market outlook and your long-term goals, to see whether you have an appropriate equity allocation.

One of our Wealth Managers can review your investment portfolio and offer suggestions as to how you might reposition your asset allocation across different areas of the market, while also recommending different money managers that specialize in those areas. Please do not hesitate to give us a call at 1-800-541-7774 to learn more, or if you prefer to start the conversation over email you can write to us at Wealth@wrapmanager.com.