Henry Blodget: The Market is Overvalued by 20%

Stocks have jumped 65% from the March lows.  They have also blasted past fair value, which is about 900 on the S&P 500 on a cyclically-adjusted price-earnings ratio (see professor Robert Shiller's chart below).  So, unless it's different this time, they're now more than 20% overvalued.

(BusinessInsider.com | Henry Blodget) (Jeremy Grantham puts fair value at 880 on the S&P 500.  That seems a bit precise.  Let's call it 900).

Of course, today's overvaluation doesn't tell you much about what stocks will do next week, next year, or even the next 5-10 years.  As the chart above shows, before the 2007 market crash, stocks were overvalued for the better part of 20 years--and observing that didn't help you make money.  On the contrary, it usually got you fired.

What today's valuation does suggest is that stocks are priced to return a bit less than average over the next decade, perhaps 3%-4% real per year (inflation adjusted), as compared to the 6%-7% average.

Today's valuations also suggest that stocks may have gotten way ahead of themselves, especially in light of the structural problems that will continue to bog down the economy.

As the chart illustrates, every one of the prior mega-busts in the past century has been followed by a "trough" in which the cyclically adjusted PE ratio hit the high single-digits.  We didn't quite make it there in March (the P/E bottomed around 12X), although we did get close.

This, combined with what is likely to be a decade of deleveraging, consumer retrenchment, and sluggish growth as we work off our debt binge, suggests that we still yet might hit that single-digit low before we take off on another secular bull market again.  This could be achieved either through another market crash, or a prolonged period of backing and filling as earnings growth gradually reduces the long-term PE ratio (this is what happened in the 1970s).

On the other hand, it is possible that that enormous stimulus and zero interest rates over the past two years will produce that "v-shaped" recovery.   At this point, given the extent of the recent rally, it would presumably have to be one heck of a "V" to send stocks soaring from here.  But the last eight months have already made idiots out of almost everyone.

SOURCE: http://www.businessinsider.com/stocks-overvalued-2009-11