To answer the question “Is the Stock Market Overpriced” we need to compare the market price to it’s relative value.
The stock market is driven by 3 factors: Fear, Greed, and Earnings. While fear and greed are the primary driver’s earnings are the root cause and ultimately sets the course.
As corporate earnings rise, the underlying value of the stock rises. This attracts more buyers than sellers, which drives the stock price higher. As earnings decline stock prices decline as sellers outnumber buyers. If earnings were the only factor we probably would never see market bubbles or crashes.
Greed rears its’ ugly head when buyers push prices higher than the rate of earnings growth. This trend can continue as long as new money continues to enter the market.
As the gap between earnings and prices widen stocks become more and more expensive relative to their underlying value. When earnings growth stalls fear begins to grow and investors will start cashing in. As long as sellers outnumber buyers prices will fall.
Fear and greed are both driven by the “herd”. When the herd begins to stampede the market can be driven to extremely overvalued or undervalued positions.
While technical analysis can tell us the current direction and momentum of the market, fundamental analysis will tell us what the market “should” be doing.
By comparing the technical indicators with the fundamental indicators we can assess the level of risk in the market.
If the market is climbing but earnings are flat or falling, market risk is rising and vice versa. Investors with a low risk tolerance will exit early at the first signs of fear. Investors with a high risk tolerance will ride it out to the end hoping to get out just in time to capture most of those final gains.
The first chart below represents the movement of the S&P 500 (C-Fund) over the past 13 years. The second chart represents the combined earnings per share of all 500 companies in the S&P 500.
As you can see, earnings have been flat to slightly declining over the past 15 months while the market continues to inch its’ way higher. In other words, market risk has been rising for over a year.
I should also note that current earnings are lower than they were in 2007 when the S&P 500 was at approximately the same point it is today. By this measurement market risk is higher today than it was in 2007.
Will earnings begin to rise to lower market risk? Will the market crash? Will the market climb further regardless of earnings? Anything is possible. All we can do is assess the risk and take action appropriate to our own tolerance for risk.