When communicating with our investors, we often say the market is over/under-bought, over/under-valued as our guidance for positioning. What exactly do we mean? In this educational post, we will explain in details. 

Technical Indicator: Overbought vs oversold

The S&P Short Range Oscillator, which has been around for decades, is a good momentum indicator that we use. It is a technical indicator. It does not account for the valuation of the S&P 500, rather only the speed and magnitude of a market move in a given direction.

When stocks move up quickly, the Oscillator increases, with a 4% and above reading signaling an overbought condition. A minus 4% and below indicates oversold conditions. Zero is neutral and a move up toward 4% or down toward minus 4% provides an idea of where the market is leaning.

For individual stocks, traders often look at the Relative Strength Indicator, which is also a momentum gauge. For this tool, 70 is the threshold at which a stock is considered overbought, while 30 is the downside threshold used to indicate an oversold condition. Last month, we answered another mailbag question and delved deeper into technical analysis.

Importantly, though, these are strictly technical analysis-oriented tools. They have nothing to do with valuation.

Valuation Indicator: Overvalued vs undervalued

To determine whether an index such as the S&P 500 or an individual stock is overvalued or undervalued requires an analysis of the price-to-earnings (P/E) valuation multiple. In the past, we have discussed how to think about appropriate multiples.

Regarding data sources for earning estimates: We use FactSet, a paid service. However, your brokerage firm should be able to offer up some resources if you reach out, or a Google search for earning estimates should also provide some useful information on forward estimates. Just keep in mind, that estimates vary so you’ll want to check out a few credible sources. 

There's never a "right" multiple for a stock or the market. Valuation is an art. It’s important to remember the multiple alone doesn’t tell the full story. It may be higher because the market is indeed expensive, or because investors think the earnings estimates are too low and need to come up. The opposite could be also true. The multiple may look low because the market really is cheap, or because investors think the estimates are too high and need to come down. That’s why we can’t look at the valuation in vacuum and need to do our analysis and ask ourselves if the estimates make sense given our worldview. 

Let's discuss the multiples of the S&P 500 as an example. In recent years, there's a range from 16 to 22 times. It is a wide range, however, we would note that the upper end includes levels reached during Covid and the time period shortly after. So, we need to consider that earnings in 2020 and much off 2021 were largely being overlooked as investors were looking for stocks that would prove cheap once earnings normalized. Put another way, the multiple got very high because investors weren’t really concerning themselves with 12-month forward estimates, they were more so thinking about the pre-pandemic 2019 level of earnings and which companies could get back to those levels the fastest.

Here’s a chart from FactSet that looks back at the forward earnings-based valuation of the S&P 500 over the past 20 years.

The two extremes to note are 2008 and 2009 (the Great Financial Crisis and the years following), as well as the 2020 and 2021 Covid years. Outside of those two periods, we think you’re probably looking at a more normalized range in, the call it, the 15.5 to 18.5 times range for the index, with an average of about 15.8 times over that timeframe.

S&P 500 forward P/E over 10 years

Over the past 10 years, not including the GFC, the range is more like 16 times to 19 times for the S&P 500, with an average of 17.8 times.

As you can see in this second chart, at the time of this writing, we are indeed at the high end of the range but not to an alarming degree. As stock pickers, we have the luxury of not worrying to much about the aggregate earnings of an index like the S&P 500 because we can focus more on our own individual investments. In other words, don’t expect us to be buying or selling solely based on the valuation of the S&P 500.

But here's the dilemma with absolute P/E valuation that we want to pose for you to think about. Why do some stocks trade at much higher P/E multiples than others, and have stayed high for sustainably long periods of time? Consider also at the index level, the multiple of the S&P 500 has slowly creeped up on average over the years? Should we expect multiples to come crashing down to historically low levels? 

S&P 500 forward PEG over 10 years

That's why we always factor in growth rate when considering multiples. You can read about PEG here. The forward P/E to growth ratio (PEG) takes the multiple and normalizes for growth rates. In the past, the market traded at lower multiples because earnings growth was lower. Nvidia may be trading at a 30x multiple compared to Ford at 10x multiple. However, Nvidia is growing earnings 30% year over year, while Ford is actually expected to earn less next year.

Let's get back to the S&P 500. Looking at the third chart above, what we find is that on a forward-looking PEG basis, the valuation of the market as measured by the S&P 500 index really isn’t that stretched – assuming of course that the earnings estimates materialize as projected or exceed expectations.

Bottom line

While trading at the upper end of the S&P 500 index valuation range, that does not rule out further gains in the market. Using our 10-year range of about 16 to 19 times current forward S&P 500 earnings estimates of $275 in 2025 puts the market at a year-end target of between 4,400 (assuming we reach 16 times 2025 estimates in December of 2024, about 4% lower than here) and 5,225 (assuming we reach 19 times 2025 estimates in December of 2024, about 14% higher), with the 17.8 times average getting us to 4,895 (about 6.5% above where we are now).

Again, a lot can happen between now and the end of the year at the level. However, as mentioned earlier, we have the luxury of concerning ourselves with the performance of individual companies, rather than the overall market, which is made up of some great companies, mostly average ones, and some awful ones. That’s exactly how we like it. 

We also think it will be a year in which diversification is rewarded. The S&P 500 is arguably at fair value at the moment given the multiples we noted above. However, it’s important to remember that the mega-caps have driven much of the gains this year. The market cap-weighted S&P 500 index has gained nearly 20% year-to-date whereas the equal-weight version has increased just under 6% for the year.

S&P 500 equal weight P/E over 10 years

As we can, on an equal-weight basis, the index, at 15.26 times is trading below its 10-year average of 16.36 times, indicating to us that there are definitely opportunities out there, outside of the Magnificent Seven that dominated 2023.