Are Equity Markets Overvalued, or Are They Just Getting Started?

Bull market stretch a sign of equity market overvaluation?

The Dow Jones Industrial Average, S&P 500, and NASDAQ continue their run of record highs. Meanwhile, investor anxiety is also hitting very high levels as participants fret about the state of the rally. Many remain very skittish after the 2000 tech bubble and 2008 financial crisis, both of which gave investors reasons to worry about overvalued markets. It's worth keeping in mind that both crashes coincided with fundamental flaws in the economy, namely the tech bubble in 2000 and the housing bubble in 2008. This time around, there are fundamental reasons that support the current move higher in equity markets. These fundamentals suggest that what we are seeing now may only be the very beginning of the next leg higher in equity markets.

It also goes back to the basics, starting with P/E ratios, perhaps the most commonly way used to valued public companies. Below is a chart of the S&P 500 earnings on a trailing-twelve-month (TTM) basis in orange, and the S&P 500 Forward Earnings Estimates (TTM) in blue. S&P 500 Earnings Per Share TTM Forward Estimate Chart

S&P 500 Earnings Per Share TTM Forward Estimate data by YCharts

This chart lets you quickly see the path of earnings growth in the S&P 500 over the years, and where they are expected to go. The earnings numbers provide a historical and forward-looking context for past and future growth in S&P 500 earnings. This view provides good, fundamental reasons for the move higher in the market. Below is a chart of the historical P/E ratios and the forward P/E ratio. 

S&P 500 P/E Ratio Forward Estimate Chart

S&P 500 P/E Ratio Forward Estimate data by YCharts

In the chart above, it's obvious that even at the current trailing P/E of 25 (the orange line), the S&P 500 isn't necessarily overvalued, based on a comparison to the last 25+ years. Meanwhile, we can see the forward P/E (blue line) actually declines to nearly 18, based on future analyst EPS expectations. Overvalued? Probably not. Why not? See below:

^SPX Chart

^SPX data by YCharts

In the chart above, you have forward EPS TTM that has increased by nearly 40% over the past year. Meanwhile, the S&P 500 has only risen by 26%. If one uses a forward P/E of 18 and forward growth rate of 38%, that gives us a one-year forward PEG ratio on the S&P 500 of .47. One could argue, the P/E of the S&P 500 has some room for more multiple expansion if we continue to sustain these levels of EPS estimates.  

Taking another backward-looking view, it is key to understand where we are in the grand scheme of things. Markets prices do not hold still in a vacuum; they are dynamic and reflective of earnings, which themselves are reflective of the economy.

US GDP Chart

US GDP data by YCharts

The chart above is of the US GDP in Blue and the S&P 500 in Orange. Notice a trend? From 1962 to present, US GDP has grown by 3,140% and the S&P 500 has increased by 3,240%. Coincidence? Not a chance. 

Above is a chart of year-over-year changes in GDP growth since 1962, and all the way to the right is where we are today. Notice any economic stagnation? Take a look on a closer scale: 

Now, here's an overlay of S&P 500 earnings and the rate of US GDP growth.

US Real GDP Growth Chart

US Real GDP Growth data by YCharts

So why is the market moving higher and taking out records? Because the market is forward looking and is starting to believe that the economic stagnation of the last eight years is about to come to an end. If expectations for economic growth begin to return to the market, then further moves up in equity markets are not impossible. Why is there so much fear building up that the market is overvalued? The fundamentals of the economy are showing signs of improvement, and that improvement should show itself in the earnings fundamentals. Even inflation is beginning to show signs of life again. (See also, U.S. Inflation Hits Four-Year High.)

Some of the moves higher in CPI are fluff, because of the year-over-year comparisons from the lows reached in energy markets last year. The CPI number should start to slow or even contract — remember oil stopped going up in June of 2016. The odds of runaway inflation are low, and that should lead to steady long-term interest rates, which will also continue to provide a tailwind to the economy and the equity market. (See also, Fed Minutes Suggest More Rate Hikes Coming Soon.)

These are all signs pointing toward the expectations of future growth in the overall US economy. If current expectations for growth fail to materialize, the market is likely to pull back and correct, and that is a real risk. If growth expectations hold steady or even grow, the current uptrend is just the start of the next cycle of the Bull Market after two years of consolidation. 

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