Overvalued Stock Market: This Chart Says It All, or Does It?

The Financial Times blog, aka FTalphaville, reproduced a chart of the price to earnings of the S&P going back in time. The chart was originally produced by Ned Davis Research. It uses the trailing twelve month reported earnings which even in retrospect were astoundingly bad. Given this data the market looks extremely overvalued, with the prior 12 month reported earnings of only $7.21 cents. Based on these historical averages for the S&P 500 over the last 50 years, for the S&P to be trading at its historically normal level the index would by at 131.65.

Chart from Ned Data Research

We certainly are not of the opinion that the market is headed down into the low triple digits. It is hard for me to imagine that this data does not take into account the massive write-downs of financial firms over the last year. It is clear that the loses and write-downs of financial firms have had an disproportionate effect on this earnings calculation. In the last few years, financial stocks have made up a large percentage of the earnings for the overall index (43% in 2006 and 28% in 2007), and clearly in 2008 the firms took the worst of the losses. If you replace one of the largest positive earnings sectors and instead make it a negative there is no doubt that overall earnings will struggle mightily.

In conclusion, this chart is far from perfect (including missing a time line on the x-axis, we assumed it was 83.2 years), but it is another illustration of where we have been. As readers of this blog know, we are worried that the market has risen to fast in the face of quite a few significant macroeconomic challenges to come. However, this chart may be casting a picture that is a little too extreme to accurately assess where we actually are now. It is far from a certainty that earnings will improve in the second half of the year, but we are pretty confident the bulk of the major write-downs are behind us and that should help make this chart look at least a little bit better. After all, the S&P’s own earnings projections for the calendar year as of 3/10/2009 was 63.74 making the current P/Estimated Earnings is 14.8x, which is much more justifiable.

This Chart Says It All, or Does It?

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Ockham Research is an independent equity research provider based in Atlanta, Georgia. Security analysis at Ockham Research is based upon the principle known as Ockham's Razor, named for the 14th- century Franciscan friar, William of Ockham. The principle states that a useful theory should utilize as few elements as possible, because efficiency is valuable. In this spirit, our goal is to make the investing environment as simple and understandable as possible, yet no simpler than is necessary.

We utilize this straightforward approach to value over 5500 securities, with key emphasis given to the study of individual securities' price-to-sales, price-to-cash earnings and other historical valuation ranges. Our long term value investing methodology is powered by the teachings of Ben Graham and it has proven to be very adept at identifying stock prices that are out of line with fundamental factors.

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