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S&P 500 closes at record high

By Sheyna Steiner ·
Thursday, February 27, 2014
Posted: 5 pm ET

The Standard & Poor's 500 index closed at a record high of 1854.30 on Thursday. The previous record was set way back on Dec. 31, 2013 at 1848.36. After a brief pullback in late January and early February, the index is back to stratospheric heights. The existential question is: Is it overvalued? What does that mean, and does it matter?

The index may indeed be overvalued, according to a recent white paper by James Montier at GMO Asset Management. The paper, "A CAPE crusader – A defence against the dark arts," (sic) looked at several methods for measuring valuations and projecting expected returns of the S&P 500 constituent companies. The paper gives some interesting insight into how analysts use models to come up with expected returns. It's a good read if you are in the mood for a foray into the impact of goodwill impairment accounting on Shiller's Cyclically Adjusted Price-Earnings ratio, or CAPE, plus other nuances that many laypeople might not give two figs about.

The paper shows the expected return of the S&P 500 based on five models over the next seven years:

Expected returns of the S&P 500 over the next 7 years

Shiller 0.8%
Full reversion Shiller -3.2%
Hussman P/E -0.6%
Tobin's Q -0.6%
Average 0

Source: GMO Asset Management

Here's what James Montier says about the above table in the paper:

If one were to exclude the theoretically dubious NIPA-based CAPE, then the average drops to almost -1 percent (per annum).

In our actual valuation work, we use a variety of different models to estimate real expected returns. One of those is indeed the Shiller P/E, but it is the most optimistic model we use. The others are more cautious, because they essentially fully revert margins back to "normal," whereas the Shiller model simply takes whatever is embedded in the most recent 10-year period.

As a general rule, we average across the various models we use to generate our best forecast as to where real returns are likely to head, rather than relying upon one signal model (without exceptionally good reason). Doing so currently results in our expectation of a -1.1 percent real return for the S&P 500 over the next seven years. We continue to believe that the weight of valuation evidence suggests the S&P 500 is significantly overvalued at its current levels. Some call us "valuation bears"; we argue that we are simply valuation realists!

So the S&P is overvalued; People may be paying more to buy the stock of those companies than earnings would indicate the companies are worth. Does it matter? Not a whole lot in the long run.

"At certain major market inflection points, some stock sectors or all sectors can be very attractive: March 2009. Or overvalued: March 2000," says Dan Dingus, president and chief operating officer, director of portfolio management at Fragasso Financial Advisors, in Pittsburgh, Penn. He's referring to the two points in recent history when the stock market reached a low and high, respectively.

"But for most investors with a diversified portfolio, inattention can be the primary stumbling block to meeting their investment goals -- not the foolhardy overhaul of stocks to one area or another. Inattention can be solved by revisiting and monitoring what you own and systematically rebalancing your portfolio back to the original allocation based on your unique goals and circumstances," he says.

Making tactical decisions to overweight value stocks and paring down your exposure to large cap growth stocks may not be the right move. Instead, selling some of the investments that have done really well recently and buying those that haven't performed as well keeps your portfolio ready for whatever the market does. No matter how fancy the models used by analysts, unless you're paying them for advice, most of what they predict is just interesting noise.

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Follow me on Twitter: @SheynaSteiner.

Senior investing reporter Sheyna Steiner is a co-author of "Future Millionaires' Guidebook," an e-book written by Bankrate editors and reporters. It's available at all the major e-book retailers.

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