The Stock Market Is Overvalued

The Dow Jones Industrial Average (^DJI 0.56%) broke new ground this week, hitting 16,000 for the first time ever. At the same time, the S&P 500 (^GSPC -0.88%) 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 (WMT 0.46%), 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 (MCD 0.37%), 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.