Right now, I hear people grappling over whether the market is overbought or, put another way, overvalued.
Well, currently both of these conditions are accurate descriptions of the broader stock market. Let's take a look and see why.
Normally, as the market goes up, there are some sectors and industries that begin to get overvalued, but there are still plenty of other sectors and industries that are either undervalued or fairly valued (when assessing the average price-earnings [P/E] ratios of the sector or industry.)
But one thing that happens near market tops or times when severe corrections come within an uptrend is that you'll be hard pressed to find any places of value within the market.
That's where we're getting to now. Not only are most all sectors overvalued along with most of the industries within those sectors, but it's getting hard to find any individual stocks within these sectors/industries that are a decent value right now.
When you have to search that hard and you find that most everything you can find is slightly overvalued to grossly overvalued fundamentally, you know you're likely nearing either a market top or a severe market correction.
Secondly, you can look at the collective valuations of companies via the S&P 500 for instance, When stocks are trading at a value, they're going to trade at a P/E ratio of 6 to 12. They're going to be fairly valued around a P/E of 15 to 16, and they're overvalued in the 18s to 20s.
Right now, the P/E of the S&P 500 is in the 19s. Historically, market tops have happened when the S&P 500's P/E was anywhere from the 18 to 19 range up to the 23 to 25 range. So this tells us that stocks are definitely overvalued here, at least fundamentally.
And since we know that they are this close to their high side, there will be very little upside left, especially relative to its potential for a downside sell-off. So the risk-reward is now flipped against the investor rather than in its favor. Therefore the savvy investors (large institutions) aren't likely to add new money to the market to help it to continue to head higher.
Thirdly, we know that the market is overbought and due for a correction simply because of how far the price of the S&P 500 is away from its 200-day simple moving average.
As I'm writing, the S&P 500 is at 1,838 and its 200-day moving average is way back down at 1,692. That's as far away from its 200-day moving average as it's been in at least the last 12 months. And each time it got anywhere near this far away from its 200-day moving average, it closed at least half the gap between its highs and the 200-day moving average.
If it closed half the gap, we'd see the S&P 500 decline to the 1,760 level. That would be a 4.2 percent correction. However, since we haven't had a correction that came all the way back to its moving average in over a year, we'll likely see a pullback to that moving average at some point in the coming weeks to months, which would end up being an 8 percent market correction.
In addition to this, typically, every year and a half or two there will be an 8 to 10 percent market correction. We haven't had one of those yet and we're overdue for one.
Again, the savvy institutional investors realize this and they're not putting a lot of money to work until they at least see a 4 percent correction. But others are waiting for "the big one," an 8 to 10 percent correction that I believe is in the cards within the months ahead.
So when you look and see that most sectors and industries are overvalued right now and you see that collectively, the S&P 500 is trading near its historical peaking points (P/E-wise) and that it is stretched very far away from its 200-day moving average — all signs for the fundamentalist and the technician point to smart investors sitting on their hands before deploying new money.
I'm a stock picker. So I'll still likely find a stock here or there that's undervalued. But I assure you, they are getting hard to find. And that means that a stock market correction is upon us. It's only a matter of time, now.
So, be wise with the stock market at these ultra-high levels. Be patient and wait for market corrections to come before deploying fresh capital. And if you want to help ensure that you're already in undervalued companies, then follow our investment picks in the Ultimate Wealth Report
About the Author: Sean Hyman
Sean Hyman is a member of the Moneynews Financial Brain Trust. Click Here to read more of his articles. He is also the editor of Ultimate Wealth Report. Discover more by Clicking Here Now.
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