Is the stock market overvalued?

Are stocks overvalued? Marketwatch editor Mark Hulbert, founder of Hulbert Financial Digest, offers two barometers which investors should look at carefully.

Hulbert's first measure is the trailing, 12-month P/E barometer; using that metric, the P/E ratio of the S&P 500 is currently greater than 1,800-to-1.

You read correctly: it's greater than 1800-to-1. And, Hulbert adds, it gets even more jaw-dropping, due to the fact that trailing, 12-month earnings for the S&P 500 are likely to drop below zero later in 2009.
Are market P/Es useful?

Of course, as the P/E's denominator gets smaller and smaller, the value of the ratio gets larger and larger, as Hulbert points out. That may compel some investors to dismiss the P/E ratio, and it's a valid critique.

Recognizes that criticism, Hulbert offers a modified P/E ratio that Yale University Economics Professor Robert Shiller (of Case-Shiller Home Price Index fame) has calculated and analyzed for decades. One advantage of Shiller's modified P/E ratio? It overcomes problems that stem from artificially depressed earnings at bear market lows: the denominator in this metric is average, inflation-adjusted earnings over the trailing 10 years.

Using Shiller's modified P/E ratio metric, the P/E for the S&P 500 is about 16.4. The 140-year average: 16.3. The 140-year median: 15.7.

With a modified P/E ratio of 16.4, one could make a strong case that the market is fairly valued. Hulbert takes the stance that, even dismissing the trailing, 12-month P/E barometer, the market is not undervalued: it's hard to argue that stocks are cheap now, Hulbert concluded.

Market Analysis: Investors should keep in mind that markets historically overshoot and undershoot both the P/E average and median. They're sort of like your highway speed, without using cruise control: the speed limit may be 60 miles per hour, but they'll be extensive periods of travel when you're doing more than 60 and periods when you're doing less.

In addition, the economic cycle can further complicate evaluations of the market's P/E. Institutional investors tend to bid-up the market, even well above the average P/E - and often for long periods of time - if they believe that better economic times are ahead; bid-down, if they believe economic conditions are worsening.

The above underscores some of the limitations of using only market P/E ratios to determine whether the market is overvalued/undervalued, i.e. whether it's a good time to buy stocks, and that's why I use a cross-methodological approach, which incorporates other technical indicators, stock and economic fundamentals, and other metrics.

One technical indicator I follow very closely: the 200-day moving average – the toughest average to break in trading. And right now the S&P 500 at 881.03 has fallen belowthe 200-day MA of 884.99. If the S&P 500 closes below that average for two more days - or three days in a row - that would be bearish for the market. If the aforementioned occurred, I'd need to see a 3-day close above the 200-day MA, with strength in other technical and fundamental indicators, before I'd turn bullish on the market again.

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Financial Editor Joseph Lazzaro is based in New York.
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