Are Stocks Overvalued?

The S&P 500 Index has returned more than 100 percent since bottoming out March 9, 2009. The strength and the speed of the rally have brought the usual debate on whether the market is once again overvalued, with some arguing that prices have risen to extreme levels of overvaluation. Those making such statements often point to two metrics:

• Tobin's Q Ratio -- the value of the stock market divided by the replacement costs of all the companies
• Cyclically Adjusted Price/Earnings (CAPE) Ratio -- the average of annual earnings per share over ten years, adjusted for inflation

At the very least, these kinds of statements cause stomachs to flutter. At the most, they cause investors to abandon well-thought-out plans. Valuations, of course, matter. The higher they are, the lower future expected returns will be. However, I don't believe that valuations are at extreme levels, or that buy-and-hold investors should worry or consider altering their asset allocation.

Consider that the current forecast for 2011 operating earnings for the S&P 500 companies is about $94. At the time of writing, the S&P 500 was trading at about 1,330, or a P/E of about 14 based on that forecast.

Admittedly, that's a forecast of full year earnings, and this is only April. In addition, forecasts tend to be too optimistic. However, even if we assume that earnings will come in at just $83 (11 percent below forecast), the P/E would still only be about the historical average of about 16. This doesn't seem to be an extreme level, especially in light of the fact that the current rate on riskless Treasury bills is zero.

One other thought is worth considering. The market is forward looking, not backward looking. And the current 10-year period used to calculate CAPE includes not just one period of economic weakness (the recent recession), but two. This provides another reason to be wary of using this metric to make any investment decision.

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