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A New Record High: Are Stocks Overvalued?

Economic downturns as well as market crashes, no matter how uncomfortable they can be, are just risks associated with stock investing. The recent spike in stock valuations, which sees U.S. as well as Canadian equities trading at record highs, has led to a growing cacophony of voices claiming that stocks are now substantially overvalued and destined for a massive correction. While the S&P/TSX Composite Index (TSX:^OSTPX) may have recently cracked the 16,000-point mark for the first time ever, there are signs that stocks may not be as expensive as many pundits believe. 

Now what?

An important gauge for determining whether stocks are overvalued is the price-to-earnings ratio, or P/E, of the S&P/TSX Composite Index. At the time of writing, the index is trading at 15,979.92; after factoring in the collective annualized second-quarter 2017 Canadian corporate earnings, this gives the index a nosebleed P/E ratio of 50.

However, that ratio is lower than what it was in early March 2017, despite the value of the index rising by 3% since then. This can be attributed to stronger corporate earnings for the first half of this year. While that ratio indicates that stocks are expensive because of the significant gap between corporate valuations and earnings, it also suggests that the gap is closing. That gap should narrow further because analysts estimate that between now and the end of 2018, corporate earnings will grow by 9% and then by 5-6% annually thereafter. This will be driven by robust economic growth and higher commodity prices.

This trend becomes apparent when reviewing Teck Resources Ltd.’s (TSX:TECK.B)(NYSE:TECK) third-quarter 2017 earnings. The miner’s quarterly profit popped by almost 8% quarter over quarter and was four times greater than a year earlier. This trend should continue through to 2018 because of firmer copper and zinc prices.

A better means of judging whether the market is overvalued is to look at what is known as the cyclically adjusted price-to-earnings ratio, or CAPE. It was developed by Professor Robert Shiller and works by taking the last 10 years of inflation-adjusted earnings data to produce a normalized P/E ratio. Using this methodology, the S&P/TSX Composite Index has a CAPE of just under 20, which is only marginally higher than the long-term average and also less than where it was in March of this year. Again, that decrease can also be attributed to improved corporate earnings.

Nonetheless, another increasingly popular indicator, because of its use by Warren Buffett, is the market-cap-to-GDP ratio, otherwise known as the “Buffett indicator.” Based on the latest GDP data from Statistics Canada, the S&P/TSX Composite Index has a market-cap-to-GDP ratio of 121%. This is 45% higher than the historical average and 6% greater than where it was in early March 2017, indicating that Canadian stocks are becoming increasingly expensive. 

So what?

There are a range of conflicting signals for investors, but they don’t necessarily indicate that stocks are overvalued or that a market correction is due. This is because GDP and corporate earnings growth is expected to remain robust for at least the foreseeable future, thereby closing the gap between stock valuations and the underlying fundamentals.

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Fool contributor Matt Smith has no position in any stocks mentioned.

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