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How can I tell if the stock market is overpriced?



New York - Generally speaking, analysts view the stock market's valuation by measuring value and sentiment. 

Measuring Value
Price Earnings Ratio - The Standard and Poor's 500 Index should be compared to historical trading ranges. For example, in early 1998, the S&P 500 PE ratio approximates 26 which is an all-time high. This compared to a ratio of 21 and 16 in 1997 and 1995, respectively.

Price/Book Ratio - This ratio represents the price that investors are willing to pay for a set amount of book value. For example, in early 1998, the S&P 500 Index was selling for approximately 5x book value which was up from 4x book value in 1997 and from 2.5x on average over twenty years. Given the growth of technology and software firms which have off-balance sheet intangibles, we believe that the ratio should be viewed within the past 10 years.

Dividend Yield - This is the rate at which company pay out free cash flow in the form of dividends. In 1998, the yield was 1.5% which compared to 3% in 1992. A lower relative yield has historically been viewed as a dangerous sign; however, some investors believe that companies are finding other use of cash such as acquisitions and stock buybacks and that historical ratios are less meaningful.

Measuring Sentiment
Bulls vs. Bears  - Many organizations and new services prepare polls that measure what investors believe will happen to the market. If more investors are bullish (the stock market will go up), this could be viewed favorably as compared to a negative consensus view.

Seats on the NYSE - The price of membership seats on the New York Stock Exchange routinely climbs during bull markets.


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