Financial Well-being

Why Do Some People Think the S&P 500 is Overvalued Right Now?

I’ve been trying to wrap my head around why some people seem to think that the S&P 500, Dow or whatever it may be is overvalued right now. Whenever I look at any returns compared to historical charting, I do not see anything to indicate overvalued stocks nor any signs of warning that indicate a correction needs to take place.

Let’s look at the historical returns for the S&P 500 over the course of 1928 to 2017 based on 10-year averages (data obtained courtesy of MacroTrends):

S&P 500 Rates of Return Percentage Change Per Decade

YearsAverage
1928-19370.66
1938-19475.11
1948-195711.27
1958-196710.28
1968-19771.49
1978-198710.58
1988-199715.48
1998-20075.52
2008-20177.90

The current decade’s average is a midline 7.90%, which is nowhere nearly as high as the 10.58% for the 1978-1987 timeframe nor the 15.48% for the 1988-1997 timeframe. Also, if you look at the returns since 1995 on a yearly basis, you’ll see the returns now are nowhere as high as years preceding a crash:

S&P 500 Yearly Return Rates Since 1995

YearReturns
199534.11
199620.26
199731.01
199826.67
199919.53
2000-10.14
2001-13.04
2002-23.37
200326.38
20048.99
20053.00
200613.62
20073.53
2008-38.49
200923.45
201012.78
20110.00
201213.41
201329.60
201411.39
2015-0.73
20169.54
201718.01

Next, if we look at the P/E Ratio for the S&P 500 from 1992 to 2017, we see that most years have been over 20. I’m taking this time period, because we have both good economic growth and stability during some of these years and two major crashes as well. It’s also the period when P/E ratios over 20 became the norm.

S&P 500 Yearly P/E Ratios Since 1992

YearP/E Ratio Average
199224.05
199322.44
199418.09
199516.03
199618.88
199721.70
199828.01
199931.69
200027.72
200134.59
200237.28
200326.95
200420.50
200518.90
200617.29
200718.69
200828.39
200983.60
201017.13
201115.14
201215.79
201317.81
201418.76
201521.94
201623.61
201723.70

Fifteen years have had a P/E ratio over 20, and eleven have had a P/E ratio under 20 (the lowest P/E ratio average being 15.14 in 2011).

Next, if we compare the S&P 500 Index Prices on a monthly basis and look for the highs and lows, we see the following periods where there were price reductions (high, low, return to high):

S&P 500 Crash Periods Since 1992

TypeDatePriceP/E Ratio
HighJanuary 1, 1994472.9921.34
LowApril 1, 1994447.2319.00
ReturnFebruary 1, 1995481.9215.11
HighAugust 1, 20001485.4627.97
LowFebruary 1, 2003837.0328.46
ReturnMay 1, 20071511.1417.92
HighOctober 1, 20071539.6620.68
LowMarch 1, 2009757.13110.37
ReturnMarch 1, 20131550.8317.68
HighMay 1, 20152111.9421.92
LowFebruary 1, 20161904.4222.02
ReturnJuly 1, 20162148.9024.52

Some of the highest P/E ratios are when the price is lowest, but not during the actual descent to the level nor during the high before the crash (whether it is a long crash or a fast crash). The P/E ratios when the highest price is reached are 21.34 in January 1994, 27.97 in August 2000, 20.68 in October 2007, and 21.92 in May 2015. These are not high P/E ratios other than the August 2000 one.

The highest P/E ratio for each of the crash periods is the following:

January 1, 1994 – 21.34

March 1, 2002 – 46.71

May 1, 2009 – 123.73

July 1, 2016 – 24.52

This corresponds to 1994 being at the high point for the crash period, 2002 being over 1.5 years into the crash and almost a year before the low point, 2009 being two months after the low point, and 2016 being when the price returned to above the prior high level.

As such, there appears to be absolutely zero predictive power for the P/E ratio in regards to determining that a crash from a high is imminent. In the longer periods of a crash (August 2000-May 2007) and (October 2007-March 2013), it appears that the P/E ratio is actually higher in the lower range and lower at the high points. The current average P/E ratio for 2017 (January to November 2017) stands at 23.70. This is approximately the same as the average 2016 P/E ratio of 23.61. November 2017’s P/E ratio is 24.80. At this point, it is not high, and if it were, it’s more likely than not we’d be in a crash period low point rather than predicting a crash is about to occur.

Of note, a more likely predictive indicator would be the margin debt, which is explained well in this article.

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