Is The S&P 500 Overvalued?

My Comments: Are you willing to bet your financial future that this time it’s different? 27 days after this was written and it’s only gotten worse.

By Aaron Hankin | April 18, 2017

Given rising geopolitical tension in the Middle East and North Korea, and rising skepticism about Trump administration policy, you could be excused for wondering just why equity markets are so resilient. In fact, so resilient that the S&P 500 is a mere 2.2 percent shy of its all-time high. The number of stock market bears grows and grows even as equities continue to climb, and some metrics back up the bears.

In a recent note entitled “S&P 500 Relative Value Cheat Sheet,” Bank of America/Merrill Lynch noted that 18 of 20 popular valuations of the stock market rate the S&P 500 as overvalued, one as high as by 105 percent.

Popular measures of equity market valuations, P/E ratios, remain at lofty levels. Ever since the Federal Reserve began its quantitative easing (QE) program, P/E ratios have climbed as equities offered more value than bond yields, but at 17.5, the forward P/E ratio of the S&P 500 remains at its highest level since 2002. According to Bank of America/Merrill Lynch, the forward P/E ratio is 15 percent overvalued compared to its historical average, the trailing P/E ratio 25 percent overvalued and the Shiller P/E ratio, which adjusts for inflation, is 73 percent overvalued compared to its historical average.

As with standard valuation methods, the S&P 500 looks overvalued against commodities. In gold terms, the S&P 500 is 20 percent above its historical average, and in WTI crude oil terms it is a staggering 105 percent above its historical average. In S&P 500 market cap/GDP terms, the S&P 500 is 85 percent above its historical average.

According to these 20 metrics, the S&P 500 is cheap compared to only Price to Free Cash Flow and S&P to Russell 2000 terms.

Metrics Suggest Bargains Can Be Found

Despite all the overvaluation rhetoric and metrics, there are some bargains out there. Bank of America/Merrill Lynch notes that even if you strip out the tech bubble, the tech sector trades at a discount with a forward P/E of 1.03 compared to its long-term average of 1.16, and if the market sees a shift back to the mean in pricing metrics there will be some tasty bargains.

“There are even greater mean-reversion opportunities at the industry level, with valuations for autos, media, airlines, biotech, and communications equipment suggesting 40 percent to 90 percent of upside if they were to snap back to long-term averages,” Bank of America/Merrill Lynch said.

The Bottom Line

With equity markets marching back towards all-time highs, a growing number of people are calling for a correction, and maybe there is some merit to the argument that the stellar run of U.S. equities is nearing an end. “Valuations typically matter little in the final stage of a bull market during which sentiment and positioning are the key drivers of returns,” Bank of America/Merrill Lynch said.