FORZA INVESTMENT FLASH - Is the Stock Market Overvalued or in Need of a Correction?

If you watch the talking heads on CNBC or read financial articles online, you've probably been hearing several so-called "experts" calling for a correction or asking whether the market is overvalued.  The US market has definitely gotten off to a fast start this year (S&P up 6.6%) and hasn't really corrected more than 5% since last October when the S&P 500 went from 1450 to 1350 in about a month.  Prior to that is was May 2012 when it corrected 9%.  For a correction greater than 10% you must go back to late July & early August of 2011 when the market dropped almost 17% in two weeks when Europe was about to disintegrate.  They also talk about how the market is up 122% since the bottom in March 2009 and it is all being driven by accommodating Central Banks. Soooo..... 

So, yes the market has come a long way in what will soon be 4 years.  But remember where we came from and how bad the climate was over those 4 years.  And yes, Central Banks around the world have been providing easy money and at some point must pull in the reigns.  Granted we are still dealing with a stubbornly slow economy and the rest of the world has its own issues, but I believe we are in far better shape than in 2008 and 2009 when we were in crisis mode in the US and Europe is seemingly on a better path than just last year. Since I am a numbers man, I decided to go back and look at the data to see where it leads. 

I pulled information together to check on valuation, dividend yields, earnings and the level of the market.  (Btw, I will be writing an article on my findings that I will send to you, but I want to summarize the results here first).  I went back to the end of 1960, since I was born in 1961 (but conceived in '60:) to see how the market was valued and performed during my lifetime.  Some of the key findings are listed below for the period 1961 thru 2012:

• Since the end of 1960, the market (S&P 500) has basically risen about the same level as the growth in Corporate earnings of the constituents over that time period.  Earnings had an annual growth (CAGR)  of 6.96% since 1960 while the market gained 6.35% annually on average.  Adding in reinvested dividends gets you about a 9.75% annual return.
• The average PE (Price/Earnings ratio) was 16.13x for the period.  At the end of 2012 the trailing PE stood at 13.92x and currently stands at 14.8x trailing earnings.   (Note:  PE ratio is a common factor used to value stocks.  It is determined by dividing the Price of the stock or Index, by the earnings per share for the last 12 months.)
• Based on estimated S&P earnings of $113 per share for 2013, the forward PE ratio is 13.4x (S&P at 1,519 / $113 per share).
• Since the end of 1999 when the S&P stood at 1469, it has only risen 3.4% IN TOTAL to the current level of 1519.  At the end of 1999, the PE ratio was 28.4x trailing earnings -- way overvalued. 
• Since the end of 1999, Corporate Earnings have grown from $51.68 to $102.47, about doubling.  The PE ratio went from 28.4x in 1999 to where it stood at the end of 2012 at 13.92x, about 1/2 where is was. 
• Since the end of 2008 corporate profits are up 57% to the end of 2012 while the market has risen --- wait for it --- 57%!

If I had to summarize the one key finding about what drives the market, it's pretty intuitive -- when it is all said and done, EARNINGS GROWTH drives the market.  If you only look back 4 years, then the market has come a long way, but so have earnings.  And if you go back to the peak of craziness in 1999, then the market has actually acted rational and allowed earnings and valuation to play catch-up.   

OK, where am I going with this you may be asking?  Right here; I don't believe that the market needs to correct because it is overvalued.  The market is reasonably valued based on history and where earnings are today.  If corporate earnings remain flat or fall, then the market should go in step.  For the market to go further without future repercussions, we need corporate profits to grow.  But right now, earnings are growing, the market is reasonably valued and the economy is growing, albeit slowly.   

Now that leaves the question of whether the market needs to take a breather because it has not corrected for a while or for some other reason.  Personally, I think a breather would be healthy for the market.  Not a -10% breather but just a few months where we go sideways and consolidate the gains we have made.  It seems inevitable that the market will take a break but I can't prove with numbers that the market does or doesn't need a break.  That's for the technicians to debate.  However, I think I laid out a historical case that the market is not overvalued based on its last 50 years of trading history -- as long as corporate earnings continue to grow.   

Sure there are still a lot of unanswered questions out there regarding a host of issues that I won't name here.  And it is fairly easy to put forth an argument why the market can correct 5% or 10%.  But I don't think valuation is one of them, unless you think we are heading back to a double-dip recession.  But that's a whole other discussion! 

Have a great week.

Bob Centrella, CFA

Bob Centrella, CFA, President/Managing Partner, Forza Investment Advisory LLC, a Registered Investment Advisor. THE ABOVE IS AN EXCERPT OF THE FORZA WEEKLY NEWSLETTER.  FOR THE FULL VERSION OF THIS NEWSLETTER, YOU CAN GO TO WW.FORZAINVESTMENT.COM AND SUBSCRIBE FOR FREE TO OUR WEEKLY NEWSLETTER.

Bob Centrella, CFA, is President/Managing Partner of Forza Investment Advisory, LLC, a Registered Investment Advisor based in Westfield, NJ. More information on Bob and Forza Investment Advisory can be obtained from www.ForzaInvestment.com.

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