The Market Is 40% Overvalued

That's what economist Andrew Smithers wrote in his most recent report to clients. Dismissing this tidbit out of hand could be costly. In Valuing Wall Street, published in March 2000, Smithers warned investors that the U.S. stock market was dramatically overvalued; over the next three years, the S&P 500 lost more than 40% of its value. In an article published on March 23rd this year, Smithers told the Financial Times, "We're not a long way short from really, really good value." The rally off the March 9 low is evidence that his assessment was again correct.

40% overvalued -- based on what?
On Oct.12, with the S&P 500 near its current level, I wrote that the market was overvalued by 16%. I based this on an analysis of the cyclically adjusted P/E multiple (CAPE), which uses a moving average of 10-year inflation-adjusted earnings.

Smithers looked at the S&P 500's CAPE also, but some technical differences in his calculations lead him to conclude the degree of overvaluation is closer to 40%. Because he's spent a lot more time thinking about the CAPE than I have, I'll give him the benefit of the doubt. Furthermore, he finds that Tobin's q ratio, which compares the market value of equities against their net worth at replacement cost, highlights a similar level of overvaluation.

"Expensive markets give low returns"
If stocks are overvalued to this degree – and there is good reason to believe they are -- investors should expect mediocre long-term returns. Certainly, there is little reason to expect permanently higher earnings growth (rather the contrary) that would compensate for the CAPE's downward reversion to its long-term average.

Consequently, value-oriented asset manager GMO estimates that large-cap stocks will return just 2.3% after inflation over the next seven years ... less than half the long-term historical U.S. equity return (6.5%).

The difference between March 2000 and October 2009
The breadth of market overvaluation in March 2000 was extraordinary. Today, the U.S. market still contains some pockets of value -- notably, high-quality companies, as exemplified by the Dow Jones Industrial Average:

Dow Jones Industrial Average

Cyclically Adjusted P/E (CAPE)

CAPE / CAPE Historical Average

March 2000 - Average

36.8

221%

September 2009 - Average

18.7

105%

Source: Author's calculations based on data from Dow Jones and Capital IQ, a division of Standard & Poor's.

A subset of stocks that were part of the index then and now tells the same story:

Stock

P/E (TTM Earnings)
March 31, 2000

P/E (TTM Earnings)
Oct. 26, 2009

Procter & Gamble (NYSE: PG  )

21.9

15.9

Microsoft (Nasdaq: MSFT  )

67.3

18.6

Wal-Mart (NYSE: WMT  )

48.3

14.7

Home Depot (NYSE: HD  )

69.1

18.5

General Electric (NYSE: GE  )

48.3

13.5

ExxonMobil (NYSE: XOM  )

34.7

11.8

Johnson & Johnson (NYSE: JNJ  )

23.9

13.1

Next steps for investors
Investors with significant exposure to the broad U.S. market should imperatively review their assumptions and consider tilting their exposure to individual names, with a careful eye toward value. High-quality stocks look like a good bet right now, for example. Failing that, Smithers' current view of the market could come back to haunt investors in the years to come -- as it has others in the past.

As we emerge from the recession, this is exactly the time to buy these stocks.

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Fool contributor Alex Dumortier, CFA, has no beneficial interest in any of the other companies mentioned in this article. The Home Depot, Microsoft, and Wal-Mart Stores are Motley Fool Inside Value selections. Johnson & Johnson and Procter & Gamble are Motley Fool Income Investor picks. The Fool owns shares of Procter & Gamble. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.


Read/Post Comments (9) | Recommend This Article (23)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 28, 2009, at 3:21 PM, cdulan wrote:

    I haven't seen an article with this type of in depth analysis in a while. Right or wrong, this is good food for thought. Good job.

  • Report this Comment On October 28, 2009, at 4:46 PM, scotthoma wrote:

    Zero percent interest will be very good for business and earnings. Shorting this market is a very dangerous proposition. Investors aren't concerned about 12-month trailing P/E; they're eyeing business potential fueled by free money; they're concerned about negative inflation-adjusted returns in money market funds and savings accounts. Days like today notwithstanding, monetary policy will continue to prop the market up.

  • Report this Comment On October 28, 2009, at 5:40 PM, kedo76 wrote:

    I predict the stock market is 32% overvalued...no wait 2% undervalued. Yeah, yeah, that's it. If I am right, then hail me a genius. If I am wrong, first, no one will ever think of my prediction but if they do then I will explain what changed that made me wrong then but why I am now onto my new predictions.

    Now, where's my paycheck as the overly educated economist that I am?

  • Report this Comment On October 28, 2009, at 6:27 PM, EquityBull wrote:

    Kedo76 - Very true...everyone makes wild calls and when they get one right everyone hails them. Even a broken clock is right twice a day. Best advice is to ignore economists. They are like opinions, everyone has one.

    scotthoma - also correct. Don't fight the fed, period. Zero interest rate policy will keep people in risk assets as the alternative is losing money in savings accounts or abysmal after tax returns from treasuries.

    The risk at some point as Buffett points out will be inflation if the Fed does not thread the needle on the liquidity. Too late and we get inflation and another bubble somewhere. Too early and the recovery will flounder.

    Best advice is to pick great companies with fair valuations and invest through up and down on periodic basis to smooth out market mania

  • Report this Comment On October 28, 2009, at 6:42 PM, TMFAleph1 wrote:

    @cdulan,

    Thanks for your comment -- I try!

    @kedo76,

    Andrew Smithers heads his own asset allocation consulting firm, Smithers & Co.; he is not a 'salaryman'.

    Smithers is directly accountable to the asset management firms he consults to -- if they did not believe his advice added any value, they would dispense with his services and he would no longer get paid. It's just that simple.

  • Report this Comment On October 28, 2009, at 7:49 PM, stan8331 wrote:

    I think that whoever is making the 40% overvaluation claim has to explain precisely what he means by it. If the market is 40% overvalued and just keeps going along that way in virtual perpetuity because people are too stupid to realize it, then as far as I'm concerned, the opinion is completely worthless.

    If the overvaluation claim means that the market will be heading back down to the March lows or worse within the next 3 months or so, then I disagree that buying ANY stock today is a good idea, because a 40% decline in the broad market will be taking all stocks down with it, good and bad alike. Some companies will drop less than others, but they'll all be dropping.

    If someone is willing to make bold claims, then they ought to be willing to give specific advice on how to take advantage of the anticipated events in the real world. Without precise specifics regarding timing (on getting out and getting back in), even if the prediction eventually comes true, those who believed it are unlikely to actually profit from it.

    If the answer is "I'm an economist, I don't deal with specifics" then the opinion isn't worth a plugged nickel to me.

  • Report this Comment On October 28, 2009, at 8:46 PM, noblhse wrote:

    No body knows what will Happen. If they did, you would not hear prognostications from them as they would be living on their Island is paradise and not making guesses about the market.

  • Report this Comment On October 28, 2009, at 8:50 PM, thisislabor wrote:

    I think it is helpful to know broad generalizations, it at least lets me know what to expect out of my WSJ later in the future when I see more "market panicing!!!" and other crazy cries. It lets me know what and why and helps me keep my own head level while I buy and sell. Just my thoughts.

    I appreciate the article, well done. I wish though you would have elaborated a little on his evaluation methods and yours, specifically what they are and how they are done. Perhaps a little text book education for us out here in poor-man's land - but, nonetheless thankyou for the article.

  • Report this Comment On November 09, 2009, at 10:59 PM, 2humble2fool wrote:

    Whomever calls seven short paragraphs and a couple of tables in depth analysis needs to find Vanna White and buy a clue. The market was over valued in March 2000? Now that's what I call really going out on a limb. If the author spent more than 30 minutes on this article I'd really be disappointed.

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