Investing

Will the market be overvalued in 12 months time

At today's valuation - yes, very.

I realize that the previous question, Is the market overvalued is not quite the correct question. The problem is that there is really more than one value of the market. There is today's value and there is the value looking forward. In the event that something is materially different in the future then the valuation has to move from the current to the future valuation.

Where this is really going is that the 20-25% overvaluation of the market based on long term averages of interest rates indicates that the market has a long way to fall when interest rates do rise. The fed model is provides a snapshot suggesting a stock valuation given an interest rate. Now we are probably at a fair value for the S&P with a fed funds rate of 3.5% but any higher than that, such as the long term 5.8% average, leads to a 20% or more overvaluation.

This can play out in three main ways:

The stock market does not increase in value until earnings catch up with the 20% overvaluation. Stagnant market for four years. -- 25% chance

Price to earnings multiples expand as interest rates decline and the market continues to move higher (somewhat unprecedented). Market keeps increasing. -- 10% chance

The stock market drops as would be indicated by the fed model and the market overshoots. Bear market upcoming a bad year in 05 - 65%

Based on my likelihood weightings (which are based on more factors than just the fed model, such as the length of bull markets) there is a lot of downside risk in the broad market right now because valuations are so high. This is not a particularly good time to buy the market. Over the next few years any opportunity to buy the market below 855 on the S&P probably has 6-10% upside per year and increasingly larger upside as you get a price better than 855.

Of course this has little to do with the economy. I expect that we will see a very prosperous economy due to the global boom. The US economy is likely to perform very well and to keep performing very well for a good few years to come. The reason stocks are risky is not because of the economy but because they are currently priced too high. This is the core argument of those in the Bull Market in a Secular Bear Market camp. Based strictly on valuations I believe they are probably correct. There will be buying opportunities in the next decade but they will be at substantially lower prices.

I read an incredibly study which timed secular bull and bear markets. It showed that secular bear markets don't end until PE ratios get down to the single digits. Now I don't think there is any reason to think that is going to happen in the near future with the economy so strong but the risk from today's valuations is ALMOST ENTIRELY TO THE DOWNSIDE

posted by Neil  # 12:23 AM