Equity Markets: Valuation is in the Eye of the Beholder

With many of the major equity indices at or near record highs it is natural to ask whether equity markets are overvalued. First of all valuations differ dramatically by geographical region and second, one’s estimate of fair valuation is to a large degree subjective. From an absolute perspective, determining whether equity markets are over or undervalued will depend on what valuation metrics are used, the time period selected for comparative analysis and most importantly the estimate of future earnings.

For example, based on information from research provider Factset the S&P 500 currently trades on a forward 12-month price/earnings multiple (P/E ratio) of 14.4. This compares to a peak of around 25 during the 1999/2000 bubble and below the 15-year average of 16.5, suggesting the S&P 500 is undervalued. However, it remains above the 5-year average of 12.9 and the 10-year average of 14.1 (which excludes the irrational exuberance of the tech boom), suggesting the S&P 500 could be overvalued.

Also, the meaningfulness of any valuation analysis depends on the reliability of the forward estimates. Prior to the previous crash when the S&P 500 peaked at 1565.15 on October 9^th 2007, the forward P/E ratio for the index was 15.2. However, as we know the economy went into a deep recession, actual earnings came in far below estimated forward earnings and the S&P 500 declined by over 50%, closing at a low of 676.53 on March 9^th 2009.

While equity markets have continued to shrug off the recent weakness in some of the macro data, a further loss of momentum in the global recovery could dampen the earnings outlook. However, at the same time weaker economic growth will force the world’s major central banks to pursue more aggressive monetary policy which has been a major positive for equities. It is a delicate balance but at present investor sentiment continues to be driven more by the outlook for monetary policy than absolute valuations.