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:

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:

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.