The Stock Market Looks Overvalued

Now it’s technically weak
by Martin F. Goldberg, MS, P.E.
Market Analyst

The chart below  which tracks stock valuations in terms of price to earnings ratio dating back from 1880 to the present, pretty much spells out the situation. The price to earnings ratio (P/E) depicted in the chart is the P/E for the S&P 500. The P/E for some other indices such as the Nasdaq 100 tends to be even higher than that of the S&P 500. P/E’s have been above the upper green line in the chart only two other times since 1880. These times were 1929 before a crash, and in 2000 before a crash. Who is to say why or how the US market has levitated toward its historical high valuation line for over 6 years since 2000? The relevant question is whether the US stock market has reached a permanently high plateau near its record high valuation point ,or if it will eventually come back to its historical valuation benchmark ranges.

Complacency abounds. A couple of weeks ago, I met with the gentleman who administers my company’s retirement program. The list of “investments” available to employees' retirement plans included an aggressive global mutual fund, which according to the administrator, is likely to average a return of 10 to 15% per year for the next 10 years. (Sign up Warren Buffett!!)

The complacency in the media has gone from high to higher. Whereas a year ago, there was Cramer, and now there is “Fast Money” and Cramer. On Wednesday, the Fast Money panelists explored how viewers could exploit the BP pipeline leak to make some “fast money.” And it probably wouldn’t be out of line to suggest that some stock recommendations on shows such as this have attempted to bring war profiteering to the average investor. The general unhealthy attitude often espoused on shows such as this seems to be, “The world is going to hell in a hay basket; but so what? Let’s try to make some money!”

The complacency with which “investors” are reacting to the newly discovered designer-corporate-crime (options grant back dating) is surprising given that credible sources state that,

“…the alleged incidents of backdating that have surfaced in the media appear to represent merely the tip of the iceberg.”

The public’s reaction to late trading in the fall of 2003 was similarly benign. Yet in spite of the corporate transgressions in recent times, corporations now pay historically low dividends to their shareholders, and shareholders do not care. Some well established companies with a history that extends over several decades pay no dividends at all. Such deviations to the basic business model are never questioned or discussed in the media. They are too busy continually tracking the body language and phraseology of the Fed and reporting on whether a favored company “beat by a penny.” In spite of the valuations illustrated in the chart above, you even get a fair share of (paid) Ivy League professors and popular brokerage commercials touting a long term buy and hold investing philosophy. You call this “investing”? With valuations as they are, for long term “investors,” I’d call it a sure road to financial ruin. But who is this writer to take issue with the herd, even if the herd includes such esteemed experts?

Until recently, there was a reason to buy or hold stocks that was separate from valuations – technicals. But now those technicals are also breaking down. For most investors, with regard to most US stocks, the sideline is the place to be. Are technicals actually breaking down? Let’s look at the long term charts of the major US stock indices.

The Nasdaq composite was in a long term linear uptrend which began over 2 years ago. The trend has recently been broken in May of ’06. There was a feeble rally whereupon the Nasdaq composite touched its down trending 10-week moving average following something the Fed Chairman said. Wednesday’s Nasdaq rally on the Cisco short squeeze, didn’t exceed last week's high. Broken trendlines and failures at an important moving average suggest that the intermediate to long term trend is now down.

Similar technical characteristics paint a similarly bearish long term picture for mid and small caps where a long term uptrend appears to have been broken. As of this moment (Wednesday evening), the trendlines have not yet been broken decisively.

The Dow Jones Industrial Average is holding up technically; although as of Wednesday evening there is a loss of weekly momentum. The favorable relative performance of the Dow is probably due to the market’s preference for value stocks versus growth stocks. The market is becoming increasingly defensive.

For those practicing Dow Theory, it appears that the transportation index is weak compared to the Dow. The transports are visiting an important long term up trendline that dates back to early spring 2004. A bounce off of that trendline back to the 40 week moving average would probably provide a good entry point to enter bearish positions.

Today’s Market

The action today was meaningless in the broad scheme of things. The only major indices that moved more than 1% were the recent laggards, semi-conductors and transportation stocks. Volume was light, further adding to the evidence that today’s action was rather meaningless. Those things that are in a bull market--oil, commodities, gold, and silver--were down, suggesting that today was an upside down day. Notable in today’s action was the apparent short squeeze in the department store, Target. Here’s the 3 year weekly chart.

The stock went up on news of results of the quarter that ended recently. While the action today was quite bullish, one does not have to be a technician to see what the market sees in Target’s future.

An intermediate term look at the small cap Russell 2000 with recent trendline and 50-day moving average suggests much more work needs to be done before a bullish trend can be declared.

Have a great evening.

Martin Goldberg

Copyright © 2006 All rights reserved. Martin F. Goldberg, MS, P.E. Market Analyst

Martin has a Master's Degree in engineering and is a Professional Engineer who successfully manages money for his friends and family. His stock market commentaries have been found in many publications and web sites around the world including Barron's. He is an affiliate of the Market Technicians Association. Martin appears monthly with Ike Iossif on www.marketviews.tv
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