The S&P 500 at Record Highs: Overbought or Undervalued?

The S&P 500 at Record Highs: Overbought or Undervalued?

iStockphoto/The Fiscal Times

If the Dow Jones Industrial Average continues to gain ground at its current pace, it will wrap up the year at close to 1,900, adding another 20 percent to its already-impressive gains. That’s the “guidance” offered by market analysts Laszlo Birinyi and Jeffrey Rubin of Birinyi Associates -- they are careful not to call it a forecast, while arguing in support of their analysis in such a way that it sounds uncannily like one.

Whether or not Birinyi and his colleague are correct in comparing the current rally to those seen in other post-recession periods the odds do seem to favor at least another week of gains for U.S. stocks. Absent any “unknown unknowns,” the kind of surprises that completely change the investment landscape, there seems to be nothing on the horizon likely to deliver a shock to the market outlook. True, Thursday brings with it the weekly initial jobless claims, but coming less than a week after a generally upbeat monthly employment report, even a bearish number is likely to be viewed as more of an anomaly than a cause for concern. Even the first-quarter earnings due to hit the market largely aren’t of the kind that will cause investors to rethink their bullishness, with a cluster of food companies (Dean, Tyson), private equity firm Carlyle Group and among them.

Here is what you need to remember, however: A market can be overbought even if it isn’t technically overvalued, and that is precisely the market environment in which we find ourselves today. And it isn’t what happens on a day-to-day basis just now -- whether the market hits a fresh high this week or retreats slightly -- that is most important, but rather, what happens over the next month or so. Will the market carry forward on its own momentum; is that momentum strong enough to address the relative absence of bullish fundamental news?

Other than the rate cut from the European central bank and some rather benign language from the Fed, there wasn’t that much news last week that could be seen as truly encouraging. Little wonder, then, that even as indexes surged to their records, investors left staring at the “risk on/risk off” continuum seem tempted to answer “neither, please.” Most “risk off” investments – the safest bonds, precious metals, etc. – look either extraordinarily pricey or uncomfortably volatile.

On the other hand, the growth rates in both revenues and earnings revealed in first-quarter releases so far haven’t offered compelling reasons to buy most stocks: While earnings have climbed an average of about 2 percent for those S&P 500 stocks that have reported their results so far, revenues have actually fallen by nearly as much. Cost-cutting doesn’t produce high-quality or sustainable earnings growth rates. (The current forecast for earnings growth for the S&P 500 for all companies in the quarter hovers around 3 percent, depending on who is doing the forecasting.)

The investments that have outperformed have been those that straddle this gap successfully, including those in defensive sectors and those offering above-average dividend yields. (That’s one reason that Apple (NASDAQ: AAPL) pushed ahead with such a large increase in its quarterly dividend, even though it has only been paying any kind of dividend for about a year.) True, investors started to focus their attention anew on some of the 2013 laggards last week – the S&P 500 Information Technology Index climbed 4.6 percent, for instance – but some other important cyclical groups aren’t likely to rally without an improvement in the global economic outlook. The ability to manage a company profitably in the midst of a low-growth/no-growth economy simply isn’t as compelling an investment proposition as is one that is riding a tailwind of solid fundamentals.

That’s why the stock market debate right now really shapes up as being about which matters most: that stocks may be overbought in the wake of this year’s big gains or that they may still be fairly described as undervalued. Both are demonstrably true: The flurry of buying has left stocks with big gains, and stock prices have grown more rapidly than underlying improvement in revenue or profits would seem to warrant.

Those with a will to believe that the current rally can continue, however, may choose to ignore this technical signal and focus instead on the valuation of the S&P 500. Over the long term, the index as a whole has tended to trade at around 15 times earnings, but the 2008/2009 crisis and the recession that followed delivered such a blow to stock prices that the five-year median valuation plunged to almost 12.5 times earnings. During 2012, the multiple rarely topped 13; today, however, the index’s valuation hovers at around 13.5 and has risen more or less steadily throughout the year.

Overbought or undervalued? The tug of war over this question will shape the market’s returns in coming months, almost as much as will fundamentals such as earnings reports and economic data. The problem for investors is that there is no definitive answer to the question. One person’s overbought market offers plenty of opportunity to another. That, in turn, means increased odds of a bumpy and uncertain few months in the stock market.