Market Overview

The Market Math On Valuations

The Market Math On Valuations

Apparently all those traders (and their computers, of course) that were spooked on Monday when Goldman Sachs (NYSE: GS) said that stocks were overvalued, took solace on Tuesday from another report out of Goldman's wealth management department that told investors to stay long.

Although Tuesday's report from GS was not overly bullish (Goldman says stocks could eek out a gain of 3 percent this year), it did seem to counteract the prior day's call to head for the hills. As such, the algos went the other way on Tuesday and the dip-buyers appeared to regain some confidence.

Such is the state of the stock market these days, where one day the computers are negative and the next, well, not so much. And with the indices currently in a fairly defined trading range, it will be interesting to see which team emerges victorious and retains possession of the ball.

So, with the near-term direction in the market a question mark at this stage, we thought it would be a good idea to continue on with our "market math" series.

The final indicator set in our review of what we call "market math" is market valuation. But before we get to the question of whether or not stocks are over-, under- or fairly-valued, we thought it would be a good idea to step back and review what we've learned so far.

Related: The Market Math On Investor Sentiment

"Don't Fight the Fed"

First, we explored monetary conditions, which, in trader parlance, is also commonly referred to as "Don't fight the Fed." Here, we learned that interest rates have been a major contributing factor to stock prices over the years. And we observed that the Fed currently remains a bull's best friend.

"Don't Fight the Tape"

Next, we looked at the "state of the tape," meaning that we explored some of our favorite trend and momentum indicators ("Don't fight the tape" has long been a vital Wall Street-ism for investors to follow). As anyone who has owned a stock over the past couple of years probably recognizes, the trend has also been a stock market investor's friend. However, we noted that the market's momentum has been waning lately, which can be viewed as a warning sign at this time.

External Factors: Sentiment Flashing a Warning

Then we started looking at the "external factors" of the market such as the economy, inflation, and investor sentiment. We learned that the economic model is currently neutral, but that stocks tend to perform a bit better than average when the model is in this mode. We learned that inflation is nowhere to be seen at the present time but that if this indicator starts to perk up, it would be a very good idea to pay attention.

We also spent some time talking about investor sentiment and how important it is to know how to use these indicators. The bottom line here is that every single one of our important sentiment indicators is currently flashing red - bright red. As such, investors may want to take their foot off of the gas and play the game a bit more conservatively than normal.

Related: More On Market Math: Economic & Inflation Indicators

Now let's move on to our final "external factor" - market valuation - and see if stock prices might be getting a bit lofty.

Valuation Lies In The Eyes of the Beholder

Perhaps the most important thing to understand about valuation indicators is that valuation lies in the eyes of the beholder. Two analysts can look at the exact same set of indicators and come up with different conclusions as to whether or not stocks are over-, under-, or fairly valued.

The Problem with Valuation Indicators Now

This is especially true in the current environment. The problem is that traditional valuation indicators such as the Price-to-Earnings (P/E) ratio stayed in a fairly definable range for 70 years. However, the technology bubble and then the credit crisis caused the range to expand - wildly.

For example, if one looks at the S&P 500's P/E ratio using GAAP (generally accepted accounting principles) earnings, the range from 1925 through 1995 was fairly definable. P/E's below 11 were considered to be "cheap" while anything over 16.5(ish) meant that stocks were considered "expensive."

The Data Has Been Skewed

However, since 1995, the GAAP P/E ratio has been under 16.5 only once. And then on the upside, the GAAP P/E was over 30 in 1998/99, over 40 in 2001/02, and was above 125 in 2009!

So, the question now becomes, what level is overvalued? Sure, the 2000 and 2009 readings were artificially inflated. But the data from 1995 makes an historical analysis difficult at best.

From 1925 through 1995, the average GAAP P/E was somewhere around 14. The average for the full period is about 17. The average for the last 50 years is 19.2. And the average over the last 25-years is nearly 25 - a level that was never once hit prior to 1990!

Therefore, it is very difficult to make a call on valuation these days without starting your assessment with a disclaimer and forming an opinion of what "normal" is at the present time.

What's the Current GAAP P/E?

Currently, the GAAP P/E for the S&P 500 is 19.11 (as of 12/31/13). But the problem is we can't really tell whether this is high, low or indifferent due to the wild swings seen over the past 20 years.

Using the full-period data, one can argue that stocks are now expensive. Using the last 50 years of data, the GAAP P/E is isn't even above average (19.1 vs. 19.2). And using the last 25 years of data, one can argue that stocks are remain downright cheap as the current 19.1 reading is well below the average of 24.9.

Therefore, using a very traditional measure of valuation, an investor can make any argument they'd like. And frankly, THIS is the reason that valuation indicators are not used in our Market Environment Model. In short, there is simply too much subjectivity involved these days.

Later, we will take a look at an alternate approach to valuations - a relative valuation model.

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