Are stocks still undervalued? -WSJ

The recent rebound in the S&P 500 — up 5.3% since May 19 — could just be a passing rally in the bear market, or it could be another leg of the bull market.

But if it turns out to be the latter, it’s almost certain that factors other than the undervaluation are helping to push the stock higher.

The eight valuation indicators that have proven to be the best predictors of 10-year inflation-adjusted returns for the stock market is a topic I’ve covered before. And while it’s possible that there are other equally effective valuation models for predicting bull markets, I haven’t discovered any.

Overall, these eight indicators at the mid-May low were more than double the average valuation of bear market lows seen over the past 50 years. And, in comparison to all monthly readings for the past 50 years, the average of the eight measurements was in the 88th percentile.

CAP fear

Let’s start by looking at the cyclically-adjusted price-to-earnings ratio, or CAPE, made famous by Yale University finance professor (and Nobel laureate) Robert Shiller. It is similar to the traditional P/E ratio, except that the denominator is based on 10-year inflation-adjusted average earnings instead of 1-year earnings. As with traditional P/E, the higher the CAPE ratio, the more overvalued the market.

On May 19, the CAPE ratio stood at 30.4. That’s more than double the average CAPE ratio at all bear market lows since 1900, according to an analysis by my firm, Hulbert Ratings, of bear markets included in a timeline maintained by Ned Davis Research. While some might think that comparisons from so long ago are irrelevant under current conditions, a comparison to more recent decades yields a similar conclusion. The average CAPE ratio at the bear market low over the last 50 years, for example, is still 17.0.

Another perspective is gained by comparing the CAPE reading at the May low with all monthly readings for the past 50 years. Even at the recent low, CAPE was in the 95th percentile of all readings, more overvalued than 95% of all other months over the past 50 years.

This message of extreme overvaluation is not easy to dismiss, since the CAPE ratio has an impressive record predicting stock market return over 10 years. You can see this by looking at a statistic known as R-squared, which ranges from 0% to 100% and measures the degree to which one set of data explains or predicts another. Measured over the last 50 years, according to my company’s analysis, the R-squared of CAPE is 52%, which is very significant at the 95% confidence level that statisticians often use to determine whether a correlation is authentic.

Many, however, reject CAPE for a variety of reasons. Some argue that the ratio needs to be adjusted to take into account today’s interest rates which, although higher than a year ago, are still low by historical standards. Others argue that the accounting changes make earnings calculations from previous decades incomparable to those of today.

Yet the same bearish signals are being sent by the other seven indicators that my firm’s research shows have impressive stock market forecasting abilities, and these indicators are based on different criteria.

Here are these seven indicators, ranked from high to low in terms of accuracy over the past 50 years in predicting subsequent stock market performance over 10 years, and showing the extent to which each indicates that the stock market remains overvalued:

• Average distribution of investor shares. This is calculated as the percentage of the average investor’s financial assets (stocks, debt and cash) that is allocated to stocks. The Federal Reserve releases this data quarterly, and even with a time lag, so there’s no way of knowing where it stood on the day of the mid-May market bottom. But at the end of last year, it was 68% above the average of 50-year bear market lows and the 99th percentile of the 50-year distribution.

• Price to book ratio. It is the ratio of the S&P 500 to book value per share, which is a measure of net worth. At the mid-May low, this indicator was 95% higher than it was at recent bear market lows and was in the 90th percentile of the distribution.

• Buffett indicator. It is the ratio of the total market capitalization of the stock market to GDP. It bears the name of

Berkshire Hathaway

CEO Warren Buffett because two decades ago he said the indicator is “probably the best single measure of where [stock market] valuations hold at some point. At the May market low, the Buffett indicator was 145% above the average of past bear market lows and the 95th percentile of the historical distribution.

• Price/sales ratio. This is the ratio between the S&P 500 and sales per share. At the mid-May low, it was 162% above 50-year bear market lows and the 94th percentile of the historical distribution.

• Q report. This indicator is based on research conducted by the late James Tobin, winner of the Nobel Prize in Economics in 1981. It is the ratio between the market value and the replacement cost of assets. At the mid-May low, it was 142% above 50-year bear market lows and in the 94th percentile of the historical distribution.

• Dividend yield. This is the dividend-per-share ratio at the S&P 500 level. This suggests the stock market is 121% overvalued from 50-year bear market lows and in the 87th percentile of the 50-year distribution.

• P/E ratio. It is perhaps the most widely followed valuation indicator, calculated by dividing the S&P 500 index by the earnings per share of its constituent companies over the last 12 months. It is currently 16% above its average level at the 50-year bear market low and the 58th percentile of the distribution of monthly readings. (This average excludes the bear market trough of March 2009, when US companies were barely profitable and the P/E ratio artificially skyrocketed to near infinity.)

Impenetrable in the short term

It should be noted that the impressive performance of these valuation indicators is based on their ability to predict stock market returns over 10 years. They are much less useful for predicting short-term stock market fluctuations. It would therefore not be inconsistent with the message of these indicators that the stock market is mounting a powerful short-term rally.

Assuming the future is like the past, however, the path of least resistance for the stock market is to decline. Short-term rallies notwithstanding, there is a good chance that the stock market as a whole will perform below average over the next decade.

Mr. Hulbert is a columnist whose Hulbert Ratings tracks investment newsletters that pay a fixed fee to be audited. He can be reached at reports@wsj.com.