Jan 9, 2020

The S&P 500 could be overvalued

Dion Rabouin, author of Markets

The New York Stock Exchange on Jan. 8. Photo: Xinhua/Wang Ying via Getty Images

The S&P 500 is too rich on a number of levels, according to calculations in a new paper from Ned Davis Research that examines the index's price to earnings, profits and price to sales.

What's happening: Not only is the benchmark stock index's current P/E ratio "well above fair value," S&P companies' prices relative to sales is at a record high, “well in excess of what they were in 2000 or 2007 at those peaks,” Ned Davis, the company's senior investment strategist, says in a note to clients.

Why it matters: Most Wall Street analysts predict that even after earnings declined overall and prices rose 30% in 2019, U.S. equities will rise modestly this year, by around 5%. But Davis warns "the long history of valuations tells me that over long-term periods, prices tend to revert to or below fair values."

  • That would mean earnings would need to increase significantly or equities prices would need to fall.

Further, "[T]he S&P 500 could be overstating earnings due to buybacks and other financial engineering of profits,” Davis says. "S&P 500 earnings have done much better than overall corporate profits for the last five years."

  • "Other measures, like the median price to earnings ratio — which exclude the skewed effects of very profitable and very unprofitable companies — shows the S&P 500 overvalued by nearly 30% versus the typical valuation level seen since 1964."
  • And “P/E ratios are some 80% above the long-term norm,” Davis notes.

The bottom line: "[T]he trend is up and the Fed is friendly," Davis says. But the numbers are the numbers. "This is a real concern."'

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