Market valuation

There is currently a high degree of nervousness over the short term direction of the stock market. Now, of course, the market direction is generally questionable on a short term basis, but there is a clear sense right now that despite the rise in market prices the economy's condition does not justify current prices.

Now, many analysts base this opinion on the rise in the market since the March lows. To use the March lows as the basis of the increase, you have to assume that valuations in March were accurate. Clearly the drop that occurred between October 2008 and March 2009 was the result of extreme fear. If you consider the market prices using a different starting point, say January 2009, you get a different picture. The S&P was about 933 in January so what we have seen is a rise of about 14% this year. If you go back one year, you see the S&P last November was also near 930 so we have a 12 month increase of 14% as well. Is this increase unjustified?

If the Stock Market is predicting economic conditions to come, it would indicate that current predictions are about 15% better than they were at the end of last year or a year ago. Considering the problems that had been uncovered and the Lehman bankruptcy, it was a very uncertain future for the economy. The stock market was predicting a very rough period accompanied by drops in valuations and high job loss. This was an accurate prediction. Now as those events unfolded, the market continued to drop and in March was effectively predicting Armageddon. However, the financial collapse did not happen and whether due to the tremendous stimulus or the natural business cycle, the economy bottomed and started to improve.

So how bad is the current valuations? Do things look 15% better than they did a year ago? I think most people would agree that they do. In fact, if the market was predicting Armageddon in March it is not unreasonable to argue that things today look infinitely better than they did in March. However, March is simply a terrible comparison point and outside of providing a wonderful buying opportunity was an abnormality.

So if you compare current valuations to a year ago of look at YTD returns, the 15% increase coming off what was already a down period is by no means outrageous. It all depends on where you start your comparison.