The S&P 500 and many other key stock indices are overpriced when measured by historical stock market valuation tools.
Share Buybacks Still Prevail on S&P 500
In the fourth quarter of 2014, the S&P 500 companies purchased over $125 billion worth of their own shares. In the trailing 12 months, they spent more than half a trillion dollars on buybacks. (Source: FactSet, March 16, 2015.) In the fourth quarter of 2014, 72% of S&P 500 companies were involved in buying back their own shares!
Investors can believe share buybacks increase shareholders’ equity. But in reality, they are nothing but a financial engineering tool to prop up per-share earnings. Instead of companies investing in growing their business by spending on research, new marketing channels, or plant or equipment, they are draining their cash buying their own stocks back. This tells me they don’t have the confidence to profitably grow their business anymore.
Whacky Stock Market Valuations
To assess the valuation of the stock market, I look at the price-to-earnings ratio that’s adjusted for cycles and price changes—also referred to as the CAPE ratio. In February, the CAPE ratio for the S&P 500 companies stood at 27.85. This is the highest it’s been since 2002! (Source: Department of Economics, Yale University web site, last accessed March 23, 2015.)
Comparing the current valuation of the S&P 500 to its historical average of 16.59, the stock market is currently overvalued by 68%! Since 1881, the CAPE ratio for the S&P 500 has gone above 27.85 just four percent of the time.
Dismal Corporate Earnings
Share buybacks may be soaring, and extreme valuations may be the norm, but when you look at corporate earnings, they are outright worrisome.
In the first quarter of 2015, companies on the S&P 500 are expected to see the biggest decline in their corporate earnings since 2009! (Source: FactSet, March 20, 2015.) Corporate earnings are expected to decline close to five percent this quarter, while revenues are expected to decline by almost three percent.
Who’s Driving the Market?
So, if corporate earnings and revenues are contracting, what’s driving the S&P 500? I don’t believe the fundamentals matter to investors any more. It’s the Federal Reserve that’s driving the stock market higher.
Take a look at the chart below. It shows what happened on the Dow Jones Industrial Average just a few minutes after the Federal Reserve hinted it may not raise interest rates as fast as it originally planned. A stock market rising on the anticipation of the Fed coming to its rescue is not a healthy market—nor a real market.
Chart courtesy of www.StockCharts.com
I’ve been very cautious about key stock indices for months. The main stock indices, like the S&P 500 and the Dow Jones Industrial Average, are overpriced by every indicator I follow. It’s only a matter of time before stocks fall flat on their face.