The stock market experienced a downturn in 2022 before rebounding in the first quarter of 2023. The S&P500 index entered a bear market after dropping more than 20% toward the end of 2022. Since then, the index has rallied more than 15%. A drawdown is generally an excellent time to acquire high-quality stocks at a reasonable price. Where is the stock market now? Is the stock market overvalued, or has it become undervalued?
Market Valuation
There are many ways to value the market. We will use the simple forward P/E ratio to gauge where we are in the stock market regarding valuation. The lower the P/E ratio, the cheaper the valuation. Please be aware of the downside of using the forward P/E ratio: it uses estimated earnings per share, so if the estimate is way off, the ratio will also be off. However, since we evaluate an index instead of an individual stock, the error usually comes from a macro event such as a recession. Keep this in mind as we look into this P/E ratio. Let us see where the current P/E ratio is compared to the historical P/E ratio.
As shown in the chart above, the current forward P/E ratio of the S&P500 is around 18.27. The median value over that period is 18.02. This means we are hovering slightly above the long-term valuation. Is the stock market cheap today? Unfortunately, it doesn’t look like so. It is not that expensive, but it is also not cheap. We would say it’s roughly fairly valued.
Using Trailing P/E Ratio
As mentioned above, the forward P/E ratio has its possible flaw, so let’s double-check using the trailing P/E ratio to confirm the valuation.
The current P/E ratio is around 23.93, while the median value over the period is about 17.82. Again, using this valuation method, the S&P500 doesn’t look cheap. It is indeed slightly expensive.
Please note that the composition of the S&P500 has evolved over the years, and it will continue to evolve in the coming years. This may have an impact on the P/E ratio that is deemed fairly valued. For example, a software technology company may deserve a higher P/E ratio than an automobile company due to the higher margin and competitive moat. Also, as the money supply continues to expand, it is natural for the P/E ratio to expand. So let’s confirm again using the data only from the past decade.
The median value over the ten years is around 23.33. Unfortunately, we cannot say the valuation is cheap. The current P/E ratio roughly aligns with the ten-year historical value. Let’s just say the market is fairly valued.
Large vs. Mid vs. Small Cap
From all the various valuation methods above, we can see that the S&P500 is not undervalued compared to its historical valuation. However, please remember that S&P 500 only tracks the top 500 companies in the US market. How about the smaller companies? Are they overvalued or undervalued?
Wow, the three charts above paint different pictures. The red line shows the current valuation relative to the historical values. For the large-cap, you can see that the current P/E ratio is way above the historical valuation. However, the current P/E ratio is way below the historical value for the mid and small-caps. If you believe this valuation method has merit, you may want to look into the mid or small-caps as their valuation is more depressed, which means a higher potential return when they revert to the mean. Please note that mid and small-caps are generally riskier than large-caps, so please ensure that you do your research and are comfortable with the associated risk.
Growth vs. Value vs. Sectors
The chart above shows that value stocks valuation is currently in the uppermost range historically. The growth stocks valuation is slightly better, though historically, it still hovers toward the upper range.
How about the valuation by sector? Is the stock market overvalued? Let’s examine them.
From the sectoral breakdown, we can see that different industries have slightly different valuations. For example, consumer staples and utilities currently have relatively high valuations compared to their historical value, while sectors like communication services are comparable to their historical valuation.
Hopefully, all the above data can answer the question: Is the stock market overvalued? Generally, the market seems fairly valued now, with a tendency toward slight overvaluation. There are pockets of the market that are more undervalued than others.
If you are a more active investor, you may want to look at sectors with relatively lower valuations and see if they fit into your portfolio. If you are a more passive investor and want to stick to the indexes, you can continue with your dollar-cost averaging strategy. The good news is that the market has dropped so much from last year that it went from being highly overvalued to between fairly valued to slightly overvalued.
But Isn’t a Recession Coming? Is the Stock Market Overvalued?
Every economist we know is expecting a recession. The market is also expecting a recession soon. If a downturn indeed comes, wouldn’t the stock valuation get crushed?
PE Expansion
Well, remember that the market is forward-looking. If everyone already expects a recession, it has been priced in. If you look at the historical data, you can see that the P/E ratio tends to expand during a recession. Why is that? In a downturn, company earning takes a hit, which means the stock price should also take a hit, right? The answer is ‘not really.’ Again, this is because the market is forward-looking. When we are in a recession, the market is already pricing in the rebound in the economy, with the corporate earnings to have rebounded as a result. This is why the P/E ratio may expand during a recession.
The question is how deep the recession will be. We may see a further pullback if it is much worse than the market anticipated. On the flip side, if the recession turns out to be much softer than expected, the market may rally. Instead of worrying about when and how bad the recession will be and trying to time the market, a rational long-term investor should make an investment plan with a proper valuation methodology and stick to it. Happy investing!
