Is the Stock Market Overpriced?

January 24, 2014

Given the monumental run of the equity markets in 2013, we have frequently been asked if the stock market (as measured by the S&P 500 index) is overvalued heading into 2014. The answer unfortunately is not a simple yes or no, because it depends on the valuation method and measurement period. This week’s Chart of the Week looks at one valuation measure, the S&P 500 trailing 12-month price-to-earnings (P/E) ratio. We compare today’s P/E ratio with its 10, 20, 30, and 40-year averages.

As the chart shows, there is no clear cut answer when comparing these different averages to the current value — the analysis is very much contingent on the time period utilized when calculating the long-term average. Based on the 20- and 30-year averages one may conclude that the market is fairly priced, if not underpriced. However, the exaggerated P/E ratios as part of the tech bubble likely provide an upward bias to truly objective “long-term” averages. Fortunately, the 40-year average is sufficient to more effectively smooth out the spikes from the Tech Bubble valuations. Using this time period to determine the long-term average, it does indeed appear that the market is overvalued and expensive by historical means. However, this is far from a guarantee that the market will experience a correction in 2014, though we encourage our clients who experienced outsized gains in their equity portfolios in 2013 to consider rebalancing back to their target ranges. If nothing else, one thing is for sure: in order to sustain this current bull market run, the S&P 500 will need to produce strong earnings growth over the next year.