Are the stocks undervalued yet? – The Wall Street Journal

Everyone wants to know when the stock market, after the recent dips, will return to good value again.

The worrying news is that even at its lowest point in mid-May, the S&P 500 wasn’t even close to being undervalued on any of the eight valuation models that my research showed have the best long-term records.

The latest bounce in the S&P 500 – up 5.3% since May 19 – could be just a passing rally in the bear market, or it could be a new bullish move in the market.

But if the latter proves to be the case, it’s quite certain that factors other than undervaluing help push the stock higher.

The 8 Valuation Indicators That Proved Best at Predicting 10-Year, Inflation-Adjusted, Returns for the Stock Market is a topic I covered before. And while there are probably other valuation models that are good at predicting bull markets, I haven’t spotted any of them.

Overall, these eight indices hit their lows in mid-May more than double the average assessment of bear market bottoms seen in the past 50 years. Compared to all monthly readings for the past 50 years, the average of the eight measurements in the 88th percentile was.

fear cap

Let’s start with a look at the cyclically adjusted price/earnings ratio, or CAPE, made famous by Yale University finance professor (and Nobel laureate) Robert Shiller. It is similar to a traditional P/E ratio, except that the denominator is based on 10-year inflation-adjusted average earnings rather than tracking one-year earnings. As with traditional P/E, the higher the CAPE ratio, the more the market is overvalued.

On May 19, the CAPE was 30.4. That’s more than double the average CAPE of all bear market bottoms since 1900, according to an analysis by my company, Hulbert Ratings, of calendar bear markets kept by Ned Davis Research. While some may think that comparisons from long ago are not relevant under current conditions, a comparison with recent decades leads to a similar conclusion. The average equity capital ratio at bear market bottoms over the past 50 years, for example, is still 17.0.

Another perspective is gained by comparing the CAPE reading at its lowest level in May with all monthly readings over the past 50 years. Even in the most recent decline, CAPE was in 95 percent of all results—more than 95% of all other months over the past 50 years.

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The message of overvaluation cannot be easily ignored, given that the CAPE ratio has an impressive track record of predicting a 10-year stock market return. You can see this when you look at a statistic known as the R-squared, which ranges from 0% to 100% and measures the degree to which one of the other data series explains or predicts. When measured over the past 50 years, according to my company’s analysis, the R-square of CAPE is 52%, which is very significant at the 95% confidence level that statisticians often use when determining whether a correlation is real.

However, many reject the Cape Town law for various reasons. Some argue that the rate needs adjusting to take into account today’s interest rates which, while higher than a year ago, are still low by historical standards. Others argue that accounting changes make earnings accounts from earlier decades incomparable with today.

However, the same bearish signals are sent by the other seven indicators that my company’s research found to have amazing stock market forecasting capabilities, and these indicators are based on different criteria.

Valuations at stock market low in mid-May

Percentage reading at stock market low in mid-May, compared to the distribution of monthly readings over the past 50 years

Most exaggerated Read the past 50 years

Most undervalued Read the past 50 years

Average shareholder equity allocation

Percentage reading at stock market low in mid-May, compared to the distribution of monthly readings over the past 50 years

Most exaggerated Read the past 50 years

Most undervalued Read the past 50 years

Average shareholder equity allocation

Most exaggerated Read the past 50 years

Percentage reading at stock market low in mid-May, compared to the distribution of monthly readings over the past 50 years

Most undervalued Read the past 50 years

Average shareholder equity allocation

Percentage reading at stock market low in mid-May, compared to the distribution of monthly readings over the past 50 years

Most undervalued Read the past 50 years

Most exaggerated Read the past 50 years

Average shareholder equity allocation

Percentage reading at stock market low in mid-May, compared to the distribution of monthly readings over the past 50 years

Most undervalued Read the past 50 years

Most exaggerated Read the past 50 years

Average shareholder equity allocation

Here are these seven indicators, listed from highest to lowest in terms of their accuracy over the past 50 years in predicting the stock market’s 10-year post-yield, and showing how much each indicates the stock market is still overvalued:

• Average shareholder equity allocation. This is calculated as a percentage of the investor’s average financial assets — stocks, debt, and cash — allocated to stocks. The Fed releases this data quarterly, and even with an interval, so there’s no way of knowing where it was on the day of the market’s low in mid-May. But at the end of last year, it was 68% above the average bear market lows of the past 50 years, and at the 99th percentile of the 50-year distribution.

• Price to book ratio. This is the ratio of the S&P 500 to book value per share, and it’s a measure of net worth. At its lowest level in mid-May, this indicator was 95% higher than it was at the bottoms of the previous bear market, and it was in the 90th percentile of the distribution.

• Buffett Index. This is the ratio of the total market capitalization of the stock market to the gross domestic product. It was named after Berkshire Hathaway CEO Warren Buffett because, two decades ago, he said, the index “is perhaps the best single measure of where [stock market] Assessments are in place at any moment.” At the May market low, Buffett’s index was 145% above the average of previous bear market lows, and at 95 percent of the historical distribution.

• Price to sales ratio. This is the ratio of the S&P 500 to sales per share. At its mid-May low, it’s 162% higher than it’s been in the past 50 years from bear market bottoms, and at the 94th percentile of the historic distribution.

• Q ratio. This indicator is based on research by the late James Tobin, winner of the 1981 Nobel Prize in Economics. It is the ratio of market value to asset replacement cost. At the mid-May low, it was 142% above bear market lows in the last 50 years, and at the 94th percentile of the historical distribution.

• Profitable return. This is the dividend-per-share ratio to the S&P 500 level. It indicates that the stock market is overvalued at 121% compared to the last 50-year bear market lows, and at the 87th percentile for a 50-year dividend.

• Price-to-earnings ratio. This is perhaps the most widely followed valuation indicator, calculated by dividing the S&P 500 by the companies’ 12-month earnings per share. It is currently 16% above its average level at bear market lows in the last 50 years, and at the 58th percentile distribution of monthly readings. (This average excludes the bear market low of March 2009, when US companies in the balance were barely profitable and the P/E ratio was artificially raised to nearly infinity.)

short-lived ambiguous

It is worth emphasizing that the impressive track records of these rating indicators are based on their ability to predict the subsequent 10-year stock market return. It is much less useful when anticipating short-term stock market volatility. Therefore, this will not contradict the message of these indicators for the stock market to reach a strong rise in the short term.

Assuming the future looks like the past, the path of least resistance for the stock market is down. Despite the short-term rises, odds are good that the stock market will yield a below-average return over the next decade.

Mr. Hulbert is a columnist who tracks Hulbert Ratings investment newsletters that pay a flat fee for their review. He can be contacted at report@wsj.com.

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