Three Market Valuation Indicators All Signal Caution
Doug Short
By Doug Short
January 4, 2011
Let's check out the latest overlays of the three valuation indicators I routinely follow. Here are links to some background explanation.
- The relationship of the S&P Composite to a regression trendline (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)
To facilitate comparisons, I've adjusted the Q Ratio and P/E10 to their arithmetic mean, which I represent as zero. 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 by 62%, 43% or 38%, depending on which of the three metrics you choose.
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 two line charts — both being 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 three approaches to market valuation, but I've included the geometric variant as an interesting alternative view for P/E and Q.
(c) Doug Short
