Weighing in on the “Stocks are Over-Valued, it’s a bubble” debate

The markets hit new highs yet most of the discussion revolves around why that shouldn’t be happening. In this post, I’d like to address the “Stocks are over-valued” argument.

I’ll be presenting three charts based on our Value Scores, Financial scores and Trend Scores. These scores are calculated on a scale from 0 (the worst) to 6 (the best) for the 6000 or so stocks that we track. A score of 2.5 to 3.5 is roughly “middle of the road”, not too bad and not too good. So scores below 2.5 are considered “poor” and scores above 3.5 are considered “good”.

When calculating the Value Score we would consider the following scenario to be equivalent to “reasonable value” with the expectation that some stocks would score even better on some or all of these parameters and be considered “deep value”

  • PE between 0 and 16
  • PEG between 0 and 1.2
  • Price-to-Sales less than 2
  • Debt-to-Equity less than 1
  • EV to EBITDA less than 10

With this first chart we get right into the value debate. This chart shows the percentage of stocks in our universe that are over-valued or somewhat over-valued; in other words, with a Value Score below 2.5

As you can see, the number of over-valued stocks has not risen much in the last year. There may have been a spike in January 2014 but the numbers have come back down and are more or less within the average range now.

At this point, you might be saying “Wait! Look how high the percentage is; almost half of stocks are at least somewhat over-valued.”

My answer is that you can’t look at a value statistic like this in isolation. It is instructive to also look at the financial condition of the market. Our next chart does just that.

To calculate our Financial score, we use a combination of PE, Debt-to-Equity, Y-O-Y Revenue Changes, Y-O-Y EPS Changes, Last quarter Cash Flow and ROE.

This chart shows that the number of stocks with mediocre to poor financials is currently up around 55%. This suggests that there are some problems lurking within company fundamentals for roughly half the stocks in the market; however, it can also be seen that the situation has been improving over the last two quarters.

Finally, if this was a bubble we would expect to see stock prices rocketing higher. Our next chart looks at Trend Performance Scores to see how many stocks are currently in solid up-trends.

Our Trend Performance Score combines the evaluation of moving averages (20-day EMA, 50-day EMA and 200-day EMA), DMI, Aroon and MACD into one trend score.

This chart indicates that barely 25% of stocks can currently be considered to be in solid up-trends. That sure doesn’t seem like a bubble to me.

Conclusion —

Unfortunately, there are no earth shattering conclusions to be drawn from our three charts; however, there are still two things that can be determined from reviewing this data.

First, the “doom-and-gloom, stocks are over-valued, it’s a bubble” crowd seem to be wrong (again). Our Valuation chart and Financial chart do indicate that not every stock is a good value or has perfect fundamentals; however, that is normal! Growth stocks (and many small caps), for example, would seldom fall into the “good value” category and would often find themselves in a less than great financial score category. The fact that our charts shows the market roughly split down the middle with half of stocks a decent value and half of stocks somewhat over-valued is not such a bad thing.

Second, with only 25% of stocks in a solid up-trend, I think the analysts and investors who say the market has more room to run are correct.

With stocks doing “more or less OK” in terms of valuation and fundamentals and the majority of stocks just muddling along in terms of price levels, it seems the path of least resistance is up.

So, no bubble. Short of some global conflagration turning markets upside down, “buy the dip” is still the order of the day.

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