Are Stocks Overvalued?

I’m going to level with you right off the bat:  I don’t have a perfectly clear answer on today’s question.
That is, I wish I could say conclusively that stocks are either overvalued or not . . . and that as a result they will either go up or down from here. But the available data doesn’t answer this question completely. So let’s just take a look at what the data says and see what reasonable conclusions we can come to.
What we know right now is that stocks are posting a banner year. With just four weeks left in 2013, the major indexes have posted 20% plus gains and are at or near record levels.
The benchmark S&P 500 is up 26% year-to-date to 1,800, posting its best year since 2003. The tech-heavy NASDAQ is up a whopping 34% to 4,048, and even the plodding Dow Jones Industrial Average is up 22% to 15,955.
Small caps have soared, with the S&P Small Cap 600 rallying 36% since the beginning of the year to close yesterday at 646.
These widespread gains have prompted “stock bubble” talk, reminiscent of the stock bubbles of 2000 and 2007. There is little doubt that some areas of the market look particularly frothy. Many tech stocks, small-cap stocks and even dividend stocks are trading at valuations that will require years of rampant growth to justify.
But as a whole, the market isn’t yet into nosebleed territory, at least not based on index P/E ratios. Yes, it’s getting up there. And yes, deep values are extremely hard to come by. But I’d say it’s more accurate to characterize the market as “expensive” than “bubbly.”
The forward 12-month PE ratio for the S&P 500 now sits at 15.0, based on the consensus forward 12-month EPS estimate of $120.00. How does this compare to the S&P 500’s historical averages? Data from FactSet shows it depends on the time period in question (see chart below).

Source: FactSet

The index currently trades above both the 5-year (13.0) and 10-year (14.0) average P/E ratios, but it still  trades below the 15-year average P/E ratio of 16.2, and it is not yet close to the bubblicious P/E ratio of 25 reached in the late 1990s and early 2000s.
One of the key differences in this market rally is that, in sharp contrast to the late 1990s and early 2000s, almost every sector of this market has rallied. Mining may be one exception, but nearly everything else, from technology to utilities, has been going up.
That broad market strength can be seen if we move down the market capitalization curve to include mid caps and small caps in the discussion. This gives us a wider sample size than just the S&P 500. The chart below shows forward P/E ratios from Yardeni Research for the S&P 500 Large Cap index (red line), S&P 400 Mid-Cap Index (blue line) and S&P 600 Small-Cap Index (green line).

Source: Yardeni Research, Thomson Reuters

As you can see, both mid caps and small caps are trading much closer to their respective forward P/E ratios from the late 1990s and early 2000s.
However, it’s worth noting that in that time period, these asset classes traded at a large discount to their larger brethren, a situation that hasn’t occurred with any regularity since the tech bubble burst in 2002. Since that time investors have been willing to pay a premium for what are typically faster-growing smaller companies. And based on index P/E ratios, investors are willing to pay up to historically high premiums today.
So where does this leave us? What looks like a good deal in a market where most indices are trading near the high range of their long-term average valuations?
I continue to recommend investors sell stocks that they don’t have very specific reasons for owning and that they don’t want to hold through market turbulence. I’d rather see investors hold cash instead of stocks that they’re just not sure about. In other words, review your portfolio and cut the fluff — cash is always good.
And I continue to recommend stocks that offer attractive risk vs. reward profiles based on specific catalysts, dividend growth and/or attractive valuations. Naturally, the specific stock in question dictates the reason.
Examples of what I like include Best Buy (NYSE:BBY) because of its turnaround story and dividend, Datawatch (NASDAQ:DWCH) because of its rapid growth and Big Data opportunity (partially because of the Panopticon acquisition) and Gilead Sciences (NASDAQ:GILD) because of its growing hepatitis C franchise.
Even though the broad market appears to be getting expensive on a forward P/E basis, stocks like these offer attractive potential returns due to very specific (and in my opinion) likely market opportunities.


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