Stock Market Overvalued by 55%?

Why It Feels Like 2007 All Over AgainOne of the oldest and most reliable ways to assess the value of the stock market is to look at its price-to-earnings (P/E) multiple. This multiple measures how much investors are willing to pay for each dollar of earnings. P/E multiples of 15 mean investors are willing to pay $15.00 for every one dollar of earnings.

When we look at the Shiller P/E multiple, it’s yelling, “The stock market is overvalued!” Shiller’s P/E multiple (adjusted for inflation) stood at 25.61 for the S&P 500 in April. (Source: Yale University web site, last accessed May 13, 2014.)

Looking at Shiller’s P/E multiple for the S&P 500 companies on a monthly basis since 1881, it has only been above 25.61 eight percent of the time. Looking at the historical average, the present value of the Shiller P/E multiple suggests the stock market is overvalued by 55%!

Despite the market being overvalued, the number of bullish stock advisors continues to increase while bearish advisors are declining in numbers (which is negative for the stock market, as it always does the opposite of what is expected of it). Not many seem to be worried about a broad market sell-off (it’s another negative when investors become so complacent).

In the chart below, you’ll see the performance of the S&P 500; below it, you’ll see the results of a recent Investors Intelligence Advisors’ Sentiment Survey, with the bulls represented by the green and the bears in red. (Source: Investors Intelligence, last accessed May 12, 2014.)

s&P 500 Large Cap Index Chart

Chart courtesy of​​​​

You will see from the chart above that those who were bearish (red) on the stock market have thrown in the towel. Their number has been declining since the bottom was made on the stock market in 2009. On the other hand, the bulls (green) have increased in number significantly.

As I have been saying in these pages for months now, the stars are lining up perfectly for a major market sell-off. All the indicators we follow remind us of 2007, just before the stock market crashed.

Individual investors are buying stocks and even conservative pension funds are rushing into the stock market. We’ve seen a sharp rise in margin debt (the amount of money people borrow to buy stocks). More and more companies are warning about their corporate earnings. Corporate revenue growth is very weak and earnings per share, in many cases, are being beaten simply because companies are buying back their stock to reduce the number of shares outstanding.

I don’t think the U.S. stock market is worth the risk. The upside potential is limited and with the chances of a market sell-off, the risks are far too great.