Is The Market Truly Overvalued?

By Glenn Curtis | September 10, 2007 AAA

There is a prevailing sentiment that the Dow (at 13,000) and the S&P 500 (at more than 1,400) are overvalued, and that stocks as a whole are overdue for another tumble.

But does this sentiment really hold water?

According to data recently compiled by Bloomberg there may be a few holes in the theory. The well-known news organization recently culled data on a bunch of companies and pointed out that software makers, for example, in the S&P were valued at an average 20.8-times estimated profit - their lowest level since 1995. Meanwhile, industrial companies traded at 18.4-times earnings. This is lower than their 10-year average of 23.4. (To read the entire Bloomberg article, see "Cheapest Stocks in Almost 12 Years Greet Investors".)

Again, the overall trend was that, historically speaking, equities are trading on the cheap.

However, just because stocks appear cheap doesn't mean they are worth buying. I believe that U.S. stocks will continue to surge forward over time given the powerful fundamentals of our economy. However, on the other hand, I think that in the next one to two years, equities still face a number of risks.

Equity Risks
I will take a while for all of the bad subprime loans and adjustable rate mortgage (ARM) defaults to work their way through the system. And there is some concern that China, which has been purchasing a large amount of our nation's debt, will ultimately stop buying. Then there are concerns over the amount of consumer debt that our citizenry has racked up in recent years. Not to mention that September and October are historically lousy months for the stock market, and that the tax selling season is just around the corner.

Sorry to ruin your day, but seriously, there are plenty of things to be worried about out there, and plenty of reasons for an investor to hedge their bets by investing in international equities, bonds, and shorter-term government debt instruments.

Recovery Indicators
With this in mind, there are signs to look for to determine if the economy and the market are really on the mend or poised to turn:

Fuel Prices
Fuel is what makes this economy run. If we get gas prices down to near, or less than, $2 again, corporate costs will plummet and earnings should soar. So, keep your eyes peeled, as this would be a good sign.

Lower Fed Funds Rate
It's great that the Fed cut the discount rate, the rate at which banks can borrow funds directly from the Fed, but it needs to cut the Federal Funds Rate, or the overnight rate at which banks borrow from each other. This will have an impact on the prime rate, and thus the rate at which many conventional loans are made. So, be on the lookout for a fed funds rate cut, as it could be a big boon for both investors and consumers. (For more insight, see Forces Behind Interest Rates.)

New Home Sales
This may not be a leading indicator, however, increased new home sales, and prices indicate that consumers have money and that they are willing to spend it. If companies such as Toll Brothers (NYSE:TOL) are ratcheting up their estimates, it's a good sign. These companies keep a close eye on the economy and construction prices.

Smart Money Abandons Defensive Plays
Pay attention to CNBC, and look for big-name institutional money managers to start promoting high technology or other speculative plays. This will signal that they expect healthy economic conditions going forward. Also, look for steady upticks in the Russell 2000 index or other signs that indicate that the masses are abandoning safer mega-cap plays in favor of smaller, potentially higher growth companies.

Tax Cuts
While I am not anticipating a tax cut anytime soon, thanks to the massive deficits our governments (both Republican and Democrat alike) have racked up, they would go a long way toward stimulating the economy.

The Bottom Line
In terms of P/E, stocks are generally cheap. However, because something is cheap doesn't necessarily mean that you should go out and buy it. Remember that although the underlying fundamentals of the economy are pretty solid, there remain a number of near-term risks that could stymie overall stock market growth for quite some time.

Looking to cook up a market-stomping stock portfolio? Check out our FREE report "7 Ingredients to Market Beating Stocks" and get started right now!

comments powered by Disqus
Related Analysis
  1. The ADX Shows Strong Uptrends In These 4 Stocks
    Chart Advisor

    The ADX Shows Strong Uptrends In These 4 Stocks

  2. Downward Trend Channels for the Market Correction
    Chart Advisor

    Downward Trend Channels for the Market Correction

  3. Oil, Oil Stocks: What The Charts Are Saying
    Chart Advisor

    Oil, Oil Stocks: What The Charts Are Saying

  4. Stocks Breaking Below Head and Shoulders Patterns
    Chart Advisor

    Stocks Breaking Below Head and Shoulders Patterns

  5. Correction-wary? Consider These Dividend Stocks
    Chart Advisor

    Correction-wary? Consider These Dividend Stocks

Trading Center