the US stock market is overvalued by 40%

The equity analysts keep repeating us that the market is cheap, but what about the technics they used to assess that?

In the latest report of Andrew Smithers, of London-based research house Smithers & Co said:

As we have remarked before, valid approaches to value are disliked by many practitioners as they get in the way of business. As is inherently likely, and as a glance at Chart 1 will confirm, the stock market has been underpriced around 50% of the time. Those who sell shares would rather it were cheap 100% of the time and therefore prefer invalid metrics. The ones used vary from time to time, as those employed are restricted to those which currently give the desired answer that “stocks are cheap“”.

In the equity world, it exists two “valid” methods to value assess the market; One is by using a cyclically adjusted PE ratio and the other by using the Q ratio, which compares the market capitalisation of companies with their net worth,  adjusted to current prices.

The answer is disturbing, for both of them, the current market is overvalued by around 40%.

In his report, Smithers explains that:

As the valid measures of the US market show that it is currently around 40% overvalued, some ingenuity is needed to claim otherwise. The EPS for the past 12 months on the S&P 500 is $7.51 so, with the index at 1071, it is selling at a trailing PE of 142. This is far higher than it has ever been before, as the previous end month record is a PE of 47. But current multiples are no guide to value; when depressed, or elevated, they need to be adjusted to their cyclical norm.(…) This is how the cyclically adjusted PE (”CAPE”) is calculated and when its current value is compared with long-term average, using the geometric means of EPS and cyclically adjusted PEs,6 it shows that the market is 37.7% overpriced using 10 years of earnings’ data and 45% if 20 years are used. This method is therefore of no use to those who sell shares, or have made faulty claims about value in the past. The following are among the most common approaches to circumventing the problem this presents. Some produce relatively small distortions, but these can amount to a substantial degree of misinformation when combined.

I hear you from here: in that case, why does the market keep rising? I would answer by another question; where do you think the money released by world’s central banks is?


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