Note from Doug: I've updated this commentary to reflect the new Q Ratio data computed from the Z.1 Flow of Funds quarterly update released today.
Here is an overview and summary of the four market valuation indicators I regularly follow:
- The Crestmont Research P/E Ratio (more)
- The cyclical P/E ratio using the trailing 10-year earnings as the divisor (more)
- The Q Ratio — the total price of the market divided by its replacement cost (more)
- The relationship of the S&P Composite to a regression trendline (more)
This post is essentially an overview and summary by way of chart overlays of the four. To facilitate comparisons, I've adjusted the two P/E ratios and Q Ratio to their arithmetic means and the inflation-adjusted S&P Composite to its exponential regression. Thus the percentages on the vertical axis show the over/undervaluation as a percent above mean value, which I'm using as a surrogate for fair value. Based on the latest S&P 500 monthly data, the index is overvalued somewhere in the range of 40% to 49%, depending on the indicator.
I've plotted the S&P regression data as an area chart type rather than a line to make the comparisons a bit easier to read. It also reinforces the difference between the line charts — which are simple ratios — and the regression series, which measures the distance from an exponential regression on a log chart.
The chart below differs from the one above in that the two valuation ratios (P/E and Q) are adjusted to their geometric mean rather than their arithmetic mean (which is what most people think of as the "average"). The geometric mean weights the central tendency of a series of numbers, thus calling attention to outliers. In my view, the first chart does a satisfactory job of illustrating these four approaches to market valuation, but I've included the geometric variant as an interesting alternative view for P/E and Q.
As I've frequently pointed out, these indicators aren't useful as short-term signals of market direction. Periods of over- and under-valuation can last for years. But they can play a role in framing longer-term expectations of investment returns. At present they suggest a cautious long-term outlook and guarded expectations.
Source: DShort.com
