The stock market has rallied hard off of the bottom that was reached in March 2009, when the S&P 500 closed at 676.53 in a selling panic over the stability of the financial system. This 75% rally has left investors to ponder the inevitable question of whether the stock market has rallied too much, or advanced "too far and too fast."
In Pictures: Biggest Stock Scams

Many investors do not feel that the current level of the market fairly reflects the underlying economic fundamentals of high levels of unemployment and foreclosures, sluggish economic growth and weak consumer spending.

Market Valuation
A first step in answering the question of market valuation is to look at the market using the common method of a price-to-earnings multiple (P/E).

This is calculated by dividing the price level of the S&P 500 index by the earnings of the companies in the index. Unfortunately, this is not as easy as it seems, because although the price level of the S&P 500 index is widely known, the earnings used in the denominator can take many different forms.

An investor can use reported earnings, which includes the impact of charges and one time items, or operating earnings, which excludes these charges. One can use forward estimates calculated by analysts, or actual trailing earnings over the prior four quarters. (To learn more, check out our P/E Ratio Tutorial.)

Current Valuation
We can obtain earnings information from Standard and Poor's, and as of the end of March 2010, we have the following estimated earnings per share for the index:

  • Estimated Reported Earnings for 2011 - $72.20 per share
  • Estimated Reported Earnings for 2010 - $62.09 per share
  • Estimated Operating Earnings for 2010 - $78.12 per share

Using the closing price of the S&P 500 on April 7, 2010 of 1182.45, the price to earnings ratio of the market is:

  • PE Ratio (Estimated Reported Earnings for 2011) - 16.38
  • PE Ratio (Estimated Reported Earnings for 2010) - 19.04
  • PE Ratio (Estimated Operating Earnings for 2010) - 15.14

If we use the trailing earnings of the S & P 500 over the previous four quarters as the denominator, we get a slightly higher price to earnings using the data in the table below:

Quarter Ending Operating Earnings Reported Earnings
12/31/2009 $ 17.16 $ 15.18
09/30/2009 $ 15.78 $ 14.76
06/30/2009 $ 13.81 $ 13.51
03/31/2009 $ 10.11 $ 7.52
Total EPS $ 56.86 $ 50.97
PE 20.80 23.20

The price to earnings ratio is slightly higher using the trailing 12 months because earnings were depressed in the first half of 2009 due to the recession. All the price to earnings ratios calculated above are slightly higher than historical ranges, and indicate an overvalued market.

The PE/10 Method
The price to earnings ratio for the market can also be calculated by using the average inflation adjusted earnings from the previous 10 years. This helps smooth out extreme outliers on earnings, which might distort the ratio. Robert Shiller, the Yale economist, has popularized this method. Using this method, the price to earnings ratio for the market is close to 22. On a historical basis, a PE/10 of 22 is in the lower part of the first, or highest quintile, also indicating an overvalued market.

The fact that the P/E ratio of the market is higher than historical averages does not necessarily mean that the market is overvalued, as there is another factor that might come into play. Since the recession that just ended was particularly harsh, earnings decreased more than expected. Investors may therefore be expecting a larger increase in earnings coming out of the trough of this recession, and bid stocks up accordingly.

What to Do
Investors might be better off ignoring the continuous and ultimately pointless argument over whether the market is overvalued, and instead adopt a value investing strategy. Value investors look for stocks that are undervalued or out of favor by investors, and adherents of value investing typically don't care about the over all market since their stock portfolios don't typically reflect the market.

To Sum It Up
The question of whether the market may be overvalued is a complicated and timeless argument that may not even mean anything to those who practice the art of stock picking. Investors should pay more attention to this than Mr. Market. (To learn more, see Stock-Picking Strategies: Value Investing.)

Check out last week's business highlights in Water Cooler Finance: My iPad Beats Your Toyota.

Want to learn how to invest?

Get a free 10 week email series that will teach you how to start investing.

Delivered twice a week, straight to your inbox.