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Are Stocks Overvalued Yet? image

It's tough to be a bear these days.

At the beginning of the year, those seeing the glass as at least half-empty were expecting Europe to drag the economies of the world into recession, China's economic growth to tank, the unrest in the Middle East to become a huge problem, the Fed to make a mistake, earnings to soften, and the politicians in Washington to send the U.S. into a depression. In short, the bears were calling for the sky to fall and for the U.S. stock market to crash and burn.

The only problem with this thesis has been that Europe's economy is actually recovering, China's GDP continues to grow at around 7. 5 percent , the situation in Syria blew over quickly, Fed policy continues to be uber-friendly, corporate earnings for the S&P 500 are at record levels, and try as they might, the politicians haven't managed to blow up the Republic just yet.

Oh and for those keeping score at home, the S&P 500 is up 21.5 percent year-to-date and finished Friday at a fresh all-time high. So, the question to the bears is how is that negative macro view working out so far?

Bears Say Stocks Are Overvalued!

Despite being dead wrong on Europe, China, the U.S. economy, earnings, and the how the market would perform in 2013, the bear camp remains largely undeterred. Instead of admitting defeat, the current battle cry is that stocks are overvalued and as such, will soon succumb to an episode of mean reversion akin to what was seen in 2000-02.

As Exhibit A in the argument, the negative Nancy's of the world point to the long-term chart of the S&P 500. The argument is that with prices as high as they currently are, the only direction they can head from here is down.

S&P 500 Index - Monthly Since 1980

To be fair, the chart above does appear to be a bit extended. And yes, it is true that the S&P has moved up an awful long way since the credit-crisis low seen in March 2009 (161.5 percent to be exact). Therefore, the argument that stocks are overvalued would seem to make some sense on the surface.

However, The Indicators Suggest Otherwise

While the performance of the S&P has been impressive lately and the current run on the monthly chart does look like it could use a rest, the facts suggest that stocks are not overvalued at the present time.

The first thing to understand is that earnings are at record highs. As such, it isn't terribly surprising to see the indices at record highs as well.

Using GAAP (generally accepted accounting principles) numbers, which are far more reliable that the "operating earnings" companies love to report, the S&P 500 is expected to produce earnings of $98.28 in 2013. This is up from the $86.51 seen in 2012, the $77.35 in 2010, and the $69.93 EPS seen in 2005. And the expectations for 2013 are roughly double the GAAP EPS from 2000, which came in at $50.

The bulls will go so far as to suggest that since earnings are almost double where they were in 2000, stocks should be higher, perhaps much higher. However, it should be noted that the environment was quite different in 2000. At that time, P/E levels were extended as investors were falling all over themselves to buy stocks, which is definitely not the case at this point.

Valuations Are No Worse Than Average

To be sure, the valuation game can be tricky. However, if one compares apples to apples over a very long time period, the bottom line is that stock valuations are just a smidge above average right now.

Here are the details using GAAP earnings on the S&P 500:

Current Price-to-Earnings ratio: 17.80
50-Year Average P/E ratio: 19.20
25-Year Average P/E ratio: 24.86
87-Year Average P/E ratio: 16.98

So, it is safe to say that no matter what time-frame is chosen, the current P/E ratio of the S&P on a GAAP basis is not overvalued.

Where Would the S&P Be Overvalued?

Based on data going back to 1926, the GAAP P/E ratio would have to be above 20.2 in order to be considered "expensive". Thus, the S&P would need to move above 1985 this year to reach the overvalued zone. For the record, that means the index could rise another 13.8 percent from Friday's close before being considered expensive.

What about next year? While projecting earnings can be a tricky business, GAAP EPS is estimated by Standard & Poor's to come in $108.29 in 2014. Based on the 87-year average, a "fair value" price for the S&P 500 would be 1839. Based on the 50-year average P/E, fair value would be at 2079. And based on the past 25-year, the S&P's fair valuation would be 2692.

Thus, assuming that stocks continue to rise until "fair value" is reached, the S&P could advance 5.4 percent from here through 2014 based on the 87-year average, 19.2 percent based on the 50-year average, and 54.3 percent if the 25-year average GAAP P/E is used.

Taking this exercise one step farther, the bears could claim that the market was overvalued if the S&P were to reach 2187 in 2014 (20.2 times $108.29), which represents an increase of 25.4 percent from Friday's close of 1744.50.

So... the bottom line is that while it may be painful for the bears to recognize, from an historical standpoint, stocks can indeed move higher from here based on valuations tied to earnings. Thus, if one is looking for a reason to be bearish, they'd best find a thesis that includes earnings falling instead of rising.

Turning to this morning... Now that the government is back to work (and employees are being paid for their time off) the focus of the stock market appears to be back to basics: earnings and economic data. Speaking of economic data, all eyes will be on the September Jobs report that will be released Tuesday morning. There is no data scheduled for release before the bell, but investors will get the report on Existing Home Sales at 10:00 am eastern.

Positions in stocks mentioned: none


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