The Stock Market Is Overvalued

The Dow Jones Industrial Average (DJINDICES: ^DJI  ) broke new ground this week, hitting 16,000 for the first time ever. At the same time, the S&P 500 (SNPINDEX: ^GSPC  ) briefly touched 1,800. With the DJIA and S&P 500 hitting record highs, it's worth checking where the market is and how it got there. Signs indicate that stocks are overvalued, earnings are abnormally high, and risks and low returns are ahead for investors.

S&P 500
For 2013, the S&P 500's earnings are expected to grow just 1.5% from 2012's level to $109.6. At current price levels, that means the earnings yield on the S&P 500 is 6%. But earnings are likely inflated because of where we are in the market cycle. The cyclically adjusted P/E is higher at 25, indicating a 2% earnings yield. At the same time, as earnings are high and stalling, the market has jumped nearly 30%. This means the stock market's rally has been based solely on people paying more money for the same amount of earnings -- this is known as "P/E multiple expansion."

Source: Damodaran, S&P Capital IQ, Bloomberg, Factset.

Investors are willing to pay 30% more for stocks than they did last year, yet at the same time, earnings are barely growing. Bulls argue that the S&P 500 is fairly valued based on 2014 forward earnings of $120 -- indicating 10% growth -- but analysts are historically too bullish. For example, in 2012 analysts forecast earnings of $115 for the S&P 500 in 2013, yet with Q3 earnings reported and 80 S&P 500 companies revising Q4 earnings estimates downward, earnings of $110 seems likely.

Earnings growth and reversion to the mean
One of the strongest forces in the world is reversion to the mean. Over the long term, market forces work to guide markets back to their long-term averages.

It's hard to see where 10% earnings growth will come from. The world is growing at 3% at the same time central banks are doing everything they can to stimulate their economies, inflation is 1%, and interest rates are at 0%. For earnings to grow 10%, corporate profit margins would have to expand from their already high levels, world growth would have to jump, or interest rates would have to fall. Each is unlikely -- in fact, the opposite is more likely.

Corporate profit margins
Corporate profit margins as a percent of the economy are already at all-time highs.

Source: Bureau of Economic Analysis, Federal Reserve.

Any way you slice it, corporate profit margins as a percent of the gross national product are 70% above their long-term average. To achieve 10% earnings growth, corporate profit margins would have to rise, and worker compensation would have to take a smaller share of the economy.

Corporate profit margins versus worker compensation
Worker compensation as a percent of GNP is near its all-time low.

Source: Bureau of Economic Analysis, Federal Reserve.

Worker compensation is currently at 51.8% of GNP -- 3 percentage points below the long-term average of 54.9%. Three percentage points might not sound like much, but to put this in perspective, if compensation were at the historical average, employees would earn $530 billion more this year.

The low wages consumers are earning look unsustainable over the longer term. And by definition, if something is unsustainable, it will end.

For example, America's largest employer, Wal-Mart (NYSE: WMT  ) , pays such low wages that its employees are the largest group of food stamp and Medicaid recipients. A report from Congressman Alan Grayson estimated that Wal-Mart employees receive $1,000 a month on average in welfare payments. Another example of how low Wal-Mart's wages are: This week a Wal-Mart in Ohio held a food drive for its own employees.

Another example: This summer America's second-largest employer, McDonald's (NYSE: MCD  ) , tried to produce a budget showing how its employees could live on the minimum wage -- and failed. A study this year found that "52% of families of fast food workers receive assistance from a public program."

American taxpayers should not be subsidizing companies' low wages, and I expect this will change. The other possibility is that as the unemployment rate gets lower and jobs get harder to fill, wages will rise as companies compete for workers. In the long term, I believe compensation will revert to the mean and we will see wage inflation, stressing corporate margins.

Economic growth
That 10% earnings growth also looks too optimistic when world economic growth is low and slowing. Some economists are even predicting U.S. growth could stagnate, similar to Japan. For growth to expand, consumers would have to spend more or companies would have to invest more, but the opposite is happening. According to an analysis by The Wall Street Journal, companies decreased capital expenditures by 16% year over year. On the consumer side, spending is slowing and in 2013 fell below 2% year-over-year growth.

This could turn around, but it would take some effort by shareholders and Congress. Companies are sitting on more than a trillion dollars abroad and are using their domestic cash to buy back stock at elevated prices. At the same time, shareholders are clamoring for income and yield. A repatriation tax holiday that gave dividends to shareholders would be a huge boost for the economy, as consumers are more likely to spend cash than companies.

Interest rates and large-scale asset purchases
The other reason corporate profits and the market are so high is that the Federal Reserve is doing everything in its power to keep interest rates down to stimulate the economy. The Federal Reserve has a zero-interest-rate policy, lending to banks for the short term at basically no cost.

The Fed has also been pursuing $85 billion a month in large-scale-asset purchases, buying long-term bonds and mortgages to force investors into other investments and keep long-term interest rates down. Low interest rates are a boon to banks and large corporate borrowers -- and the bane of savers who are getting low returns on their savings.

One problem, though, is that the Fed's purchases don't appear to be working as well as hoped. The Fed has purchased $4 trillion in assets so far, and interest rates are back to where they were before the Fed's spending spree. Without the Fed's purchases, interest rates would be somewhat higher.

The Fed can't keep purchasing $85 billion of assets each month without threatening the stability of the financial system. Every hint from the Fed that it will end its purchases has been met with steep sell-offs and Fed officials recanting. At some point the Fed will have to stop its purchases.

The problem is that no one knows what will happen when it does. Even Federal Reserve Chairman Ben Bernanke said as much this week: "We are somewhat less certain about the magnitudes of the effects on financial conditions and the economy of changes in the pace of purchases or in the accumulated stock of assets on the Fed's balance sheet."

The Fed is continuing its asset purchases for now, and no one knows when it will bring them to a halt. 

Foolish bottom line
The stock market is overvalued, and earnings look cyclically high. That said, predicting where the broad market will go in the short term is a game for fools (with a lowercase "F"). Stocks can always get more overvalued. When things get frothy, it's worthwhile to build up some cash on the side for when prices inevitably fall.

The Motley Fool has always taught that Foolish (capital "F") investors don't invest in the broad market. We invest in great companies at good prices, continue to educate ourselves, and hold on to our great companies over the long term. The market will fluctuate (sometimes massively), but great companies will win out over the long run.

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Read/Post Comments (13) | Recommend This Article (30)

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 November 21, 2013, at 5:45 PM, walithomas wrote:

    Duh!!!

  • Report this Comment On November 21, 2013, at 8:41 PM, bburr4307 wrote:

    Very interesting story. A different outlook than I have heard before, and one that makes sense. Will diffinently think about the views written in this article for the future. (I like the no bias approach also).

  • Report this Comment On November 22, 2013, at 9:02 AM, kewlness wrote:

    I am not 100% sure I agree with this assessment. During the recession, companies did a lot to shave costs meaning a lot of today's companies are leaner and meaner with higher margins. While I believe a correction is inevitable in the very near term, I do not believe it will be as big as this article seems to make it appear.

    Of course, I have been known to be wrong before... :o)

  • Report this Comment On November 22, 2013, at 9:13 AM, Mathman6577 wrote:

    No one has been able to predict the course of the market over the short-term.

    And I see more Wal-Mart bashing here -- article could have been written by the unions. For some reason the Fool has been bashing WMT a lot lately for its "labor practices". Better watch out. If you keep bashing them and they are forced to increase wages (and prices) it could hurt the overall economy. Wal-Mart comprises a fairly good chunk of the overall economy and labor market. Let's pump up stocks --- not bash a company for being successful. If you don't like a company don't buy its stock, don't shop there, and don't work there

  • Report this Comment On November 23, 2013, at 12:33 PM, thebigcicero wrote:

    Good article, thanks. About the Profit/GNP chart: I have read many a-time about this chart being indicative of general valuations. But looking at the chart doesn't seem to reflect historical valuations. Look, for example, at '82-'00. The chart never goes above the average, while valuations were quite frothy for much of this period. Same goes for '76-'79, when stocks were cheap but no one would touch them and profits were high. This chart, as you imply, probably needs to be used in conjunction with multiples to determine possible expansion, plus interest rates. In today's case, as profits may revert and interest rates will eventually climb, you have impending headwinds to rising prices. But multiples may yet expand, leading still to a rising market. Moral of the story: it's hard to predict future market conditions!!

  • Report this Comment On November 25, 2013, at 9:36 AM, Jamesband wrote:

    Just imagine the possible salary potential if there were no forced minimum wage in the service industry or any other industry. True story… I walked into a BK over the weekend, I think it was my second time this year, and ordered a Double Whopper with Cheese, and a glass of water. And let me clarify the setting at the time…. 3 front end workers, and two cooks in the back as I could see. Now, to begin with I did not get my water, instead they charged me for a small soft drink, no bother I went with it, then, at my table (yes I ate inside), my DW/C turned out to be a single Whopper, so I took it back to the counter and they added an additional burger by opening up my sandwich and slapping another cold burger in it. Then, back at the table, I took my first bit, and what was missing then… you guessed it, the cheese. So I took it back , for the third time, to the counter and then the unbelievable… they charged me for a slice of cheese, opened the sandwich back up and slapped a slice of cheese on it, I kid you not! Now, is there any question that a minimum wage is good for your company? Raising the minimum wage will continue to propagate substandard workers and worker environments. Minimum wage poisons the worker pool, especially potentially good workers. If good employees are forced to except the same government enforced pay as terrible employees, all incentive to improve or do better for said company is gone… kaput! Market wages, on the other hand, are based on competency and skill, and best of all competition. Your company will never achieve this goal from a forced government wage requirement, minimum or otherwise, and it’s the otherwise that scares me. The next government overreach will be to set pay scales based on work requirements, when this happens capitalism is dead, our economy will suffer permanent damage.

  • Report this Comment On November 25, 2013, at 10:57 AM, FutureMonkey wrote:

    Nice analysis, especially ETF investor following Modern Portfolio Theory and rebalance semi-annually then you probably are going to sell off some US-centric indexs and pick up other asset classes. Such as emerging market, all-world ex-US stock ETF, and bond funds, etc. Not a bad approach to unemotional, long term investing with a substantial chunk of your portfolio that will likely beat the SP500 and certainly will beat paying a money manager to do the same thing at 1%.

    However, as you say, TMF approach is not to "invest in the broad market. We invest in great companies at good prices, continue to educate ourselves, and hold on to our great companies over the long term. The market will fluctuate (sometimes massively), but great companies will win out over the long run." In that regard, paying too much attention to these sorts of charts can be a distraction and lead to paralysis or selling inappropriately. Getting clever and trying my hand at market timing has caused me more regret than anything. Up down sideways - whatever, I prefer to dollar cost average and accumulating positions in stocks chosen based on a combination of thoughtful analysis and instinctual response.

    FM

  • Report this Comment On November 25, 2013, at 11:02 AM, crackdclaw wrote:

    "The Motley Fool has always taught that Foolish (capital "F") investors don't invest in the broad market."

    Could have F(f)F? ooled me! When I began reading the Fool the investment strategy preached was to buy index funds.

  • Report this Comment On November 25, 2013, at 11:21 AM, SkepikI wrote:

    As chronicled elsewhere and in numerous MF articles, while the trends in your charts are informative, the actual correlations with results over time are pitiful. The ONLY metric that has ever show anything like a correlation is P/E ratio according to literally scads of research, AND that correlation though positive is very poor, less than .25 as I recall.

    All that said, there simply does not seem to be anything on the horizon other than the Feds repression of rates to make these kind of pitiful returns attractive. Put another way, for some people, if your alternative return is less than 1%, then 2% looks pretty good if you ignore the risks.

    RISK adjusted, however, one really ought to imagine that any small reversion, or decline from outrageous valuations like say only 10% will wipe out your income for....gulp 5 years. Not a comfortable place to be. Still, if you see the demographics and stunning productivity improvements driving enormous gains in profits over the next five years, you might well wish to plunge in aggressively..... ; -)

    I plan to re-balance aggressively and hunker down till the inevitable correction, which hasn't happened now for way too long.

  • Report this Comment On November 25, 2013, at 12:43 PM, kewlness wrote:

    crackdclaw stated:

    "Could have F(f)F? ooled me! When I began reading the Fool the investment strategy preached was to buy index funds."

    Kinda. The Motley Fool is written with the focus on educating people how to invest. Remember, back when the Fool started, mutual funds were a really big thing and ETFs were relatively new (in the sense that the general public knew what a mutual fund was but couldn't tell you what an ETF was). The Fool realized people could invest in ETFs and do well with very little commitment. However, for those who wanted to spend the time, they were willing to show anybody who would listen how to pick market-beating stocks.

    Those of us who have stayed around and learned have profited in both wealth generation and knowledge. Are you one of those Fools?

  • Report this Comment On November 25, 2013, at 12:58 PM, Chilaw wrote:

    Comparing profits to US GDP is less useful today since so much of S&P profits now come from abroad. Any analysis of S&P needs to look at the global economy.

    Investment is all about your alternatives and, no matter the valuation concerns, bonds look scarier than stocks. Unless you want to gamble with commodities or currencies, equities are still the best bet. Having said that, some cash buildup is probably prudent.

  • Report this Comment On November 25, 2013, at 1:30 PM, Risky88 wrote:

    Minimum wage is bad you person says?!

    You work as hard as you get paid

    Now thats

    Free Market principled.

  • Report this Comment On January 31, 2014, at 2:41 AM, thidmark wrote:

    Hard to take a loon like Alan Grayson seriously

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