Stock market valuation indicators signal caution

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In order to gauge the valuation of the S&P 500 Index, let’s consider three indicators constructed by Doug Short:

  • The relationship of the S&P 500 to a regression trendline (more)
  • The cyclical P/E ratio using the trailing 10-year earnings as the divisor (more)
  • The Q Ratio – the total price of the market divided by its replacement cost (more)

“To facilitate comparisons, I’ve adjusted the Q Ratio and P/E10 to their arithmetic mean, which I represent as zero. Thus the percentages on the vertical axis show the over/undervaluation as a percent above mean value, which I’m using as a surrogate for fair value,” said Doug.

According to this methodology, the Index is overvalued by 63%, 43% or 38%, depending on which of the three metrics you choose.

Click here or on the image below for a larger graph.

Source:, January 4, 2011.

Whichever way one looks at the stock market at the moment, it is hard not to conclude that the nascent bull run is overextended in the short term – overvalued from a fundamental point of view, overbought from a technical perspective and overbullish as far as the sentiment indicators go. As said before, a pullback is overdue in order to restore the risk/reward balance.

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