On any given day we can find a wide range of opinions as to whether the stock market is undervalued or overvalued, and the bases for these assessments are also wide ranging and sometimes overly optimistic. I think a good starting point for estimating value is to use a price to earnings ratio (P/E) based upon twelve-month-trailing “as reported” or GAAP earnings (calculated using Generally Accepted Accounting Principles). I do not assert that this is necessarily the best method, but it is simple, easy to understand, and doesn’t rely on assumptions about future earnings. The normal range for the GAAP P/E ratio is between 10 (undervalued) to 20 (overvalued). The following chart shows the S&P 500 Index in relation to this range.
As you can see the S&P 500 has reached the top of the normal range and is overvalued. This kind of situation doesn’t always lead to disaster, but it tells us at the very least that conditions are not ideal for major new commitments to the long side. A price reversal is possible, but it is also possible that earnings will continue to rise, creating a rational environment for prices to continue higher. The bottom line is that valuations are unfavorable, making the market more vulnerable in this regard.
Watching the windsock,