What Is The Market Saying?: CAPE and q

With the S&P500 having recently reached withing fifty cents on a closing basis of a new high recently, I think it is prudent to have a look at what some market valuation indicators are saying. We have referred to this source before. This is an image from Smithers & Co.which I believe to be the ultimate authority on stock market valuation as calculated in q, that being the value of the replacement cost of corporate assets. The chart, which also includes Shiller's cyclically adjusted 10 year values of price earning ratios (CAPE10) shows the q ratio against its geometric mean, thereby yielding a percentage above or below fair value. Fair value is assumed to be equal to replacement cost. For a more in depth discussion of the rationale for this measure, please refer to Smithers' two books: Valuing Wall Street and Wall Street Revalued.

So what is this tool saying? Let's have the folks at Smithers & Co. spell it out for us:

With the publication of the Flow of Funds data up to 31st December, 2012 (on 7th March, 2013) we have updated our calculations for q and CAPE. Over the past year net worth has risen by 7.6%, with the most significant rise being in the value ascribed to real estate (+ 5.9%). Interest-bearing assets have risen by 5.8% while interest bearing liabilities have risen by 8.2%.

Both q and CAPE include data for the year ending 31st December, 2012. At that date the S&P 500 was at 1426 and US non-financials were overvalued by 44% according to q and quoted shares, including financials, were overvalued by 52% according to CAPE. (It should be noted that we use geometric rather than arithmetic means in our calculations.)

As at 12th March, 2013 with the S&P 500 at 1552 the overvaluation by the relevant measures was 57% for non-financials and 65% for quoted shares.

Although the overvaluation of the stock market is well short of the extremes reached at the year ends of 1929 and 1999, it has reached the other previous peaks of 1906, 1936 and 1968. (here)

Sixty five percent! I have opined elsewhere on the difficulty of using this information as a timing tool. Both it and CAPE10 are measures that require a long term (10 years?) view in order to even consider its use. In fact, Smithers & Co. publish this information only quarterly, when they have verifiable sources for its calculation (Federal Reserve Flow of Funds data, etc.). Nevertheless, this measure has to give anyone considering new investments in the market great pause-- and existing investors a test of their tolerance potential for losses. Of course the overvaluation was MUCH worse in 2000 and slightly worse is 2007. The former led to losses of nearly 50% and the latter to greater than 50% losses. Yet here we are again with the S&P500 at the 1550 level and the market seemingly rich by a significant margin. Caveat emptor.