Is The S&P 500 Overvalued?

With another earnings season and a voracious market rally in progress, it might be wise to look at whether or not stocks are valued fairly at current prices. The answer is “probably not.” Investors need not look any further to the price-to-earnings ratios. The S&P 500 P/E ratio based on reported earnings as of 9/30/09 was a whopping 140.76, according to Standard & Poors data.

Since the market has moved higher since September 30, it’s logical to assume that lofty P/E number has moved even higher. As of June 30, the trailing four quarters produced per share earnings of $7.51 a share for S&P 500 member companies. Earnings for the comparable period in 2007 were nearly $85 a share, for a P/E ratio of just under 18.

Clearly stocks are trading at extremely lofty levels. But does that mean the market will deliver some downside over the near-term? Maybe, maybe not. The rise in P/E multiples from the March lows has been staggering across the board but especially so in certain sectors. Materials stocks have seen their sector P/E more than triple while valuations on industrials names have more than doubled. Technology and energy names have near-doubles as well. Even the “laggards” such as healthcare and consumer discretionary stocks are up 29% and 20%, respectively.

Financial services is currently the only sector with a negative P/E ratio, so one can only surmise how expensive the S&P 500 would look if its second-largest industry group was turning a profit. These numbers certainly indicate stocks have made their way to some lofty levels. The bar has been set so low that most decent companies have little difficulty in beating analysts’ estimates. This, in turn, drives stocks higher.

The bar will almost certainly be raised for the fourth quarter. If stocks can meet or beat higher estimates, the rally could be extended. Eventually the market’s weak leadership will be exposed, maybe when the investment herd decides unemployment is too high.

Whatever the catalyst, consider profits before you click the buy button again. Companies that are losing money can still go up, but in the long run profit growth is what drives prices higher.