Are U.S. Stocks Overvalued? Some Money Managers Think So

The U.S. stock market continues to operate on a “full speed ahead” blueprint, with the 2017 Dow Jones Industrial Average up a roaring 10 percent through the first seven months.

Can it continue? Stock market numbers do stack up in the bull’s favor.

“Another quarter with double-digit, year-over-year earnings growth for the S&P 500 appears likely for the second period, but it won't match the pace of the first quarter,” wrote Fusion Wealth Management in a new research note.

While annual comparisons are getting tougher with the one-year anniversary of the 2015-2016 earnings recession trough having passed, Fusion analysts are generally optimistic about the U.S. stock market going forward.

“We have several reasons to be optimistic, as was the case last quarter, including generally good macro data and resilient analysts' earnings estimates,” the company said. “Second-quarter earnings growth will be about more than just an energy rebound, with solid contributions expected from technology and financials.”

'Equities Are Overvalued'

That’s all good news for advisors and clients, but doubts are on the rise. One key question for advisors working on client investment strategies for the second half of 2017 is a simple one – are U.S. equities overvalued or not?

Some money managers think that’s exactly the case.

“U.S. equities are overvalued,” said Jason Pride, director of investment strategy at Glenmede.

U.S. price-to-earnings ratios are at their highest levels since the global financial crisis, he added, with the current normalized P/E ratio for large cap at 18.9x.

“Such valuations are at the 76th percentile of long-term normal ranges, though they have the ability to stay overvalued for prolonged periods,” Pride said.

International equities are “more fairly valued, at normalized P/E ratios of 16.6x and 13.6x for developed and emerging markets, respectively, both of which are only slightly above their historical median levels,” he said.

The overvaluation of U.S. equities may persist, but international equities have more room for upside, Pride said.

Some advisors say the end of the quarter – especially the quarter that bridges the first and second halves of the year – is a good time for some old-fashioned market introspection.

“The current bull market may be an opportunity to take a pulse of your portfolio's allocation to U.S. equities,” said Maggie Johndrow, a money manager with Farmington River Financial Group in Farmington, Conn.

When looking at fundamentals, such as the forward P/E ratio, the stock market is above the 25-year average, Johndrow said.

“As of June 30, 2017 the forward P/E ratio for the S&P 500 is 17.5x,” she said. “While this may seem high, historically we have experienced higher forward P/E ratios before a market correction.”

For example, at the start of the correction in late March 2000, the forward P/E ratio was 27.2x, she said.

“Consequently, perhaps the market still has some ways to go,” Johndrow noted. “That said, in October 2007 the forward P/E ratio was lower than where the S&P 500 is now at 15.7x. Certainly we are in between these numbers, so some anticipation of a correction may be warranted.”

U.S. Stock Still Favored

On the other hand, the economy still looks to favor U.S. stocks, Johndrow said.

“First-quarter earnings were up across the board, with 10 of the 11 sectors in the index reporting year-over-year growth,” she said. “High earnings may lead to expedited growth, suggesting that strong stock market performance may continue.”

Interest rate movements could also play a huge role in steering the U.S. stock market in one direction or another.

“Given where interest rates are -- and the fact the 10-year Treasury bond is yielding 2.37 percent -- historically high stock valuations may very well be justified,” said Robert Johnson, chief executive officer at The American College of Financial Services, in Bryn Mawr, Pa.

In an interview with Yahoo Finance’s Andy Sewer this April, Warren Buffett was quoted as saying “Everything in valuation gets back to interest rates.”

Following the Berkshire Hathaway Annual Meeting, Buffett said, “if these rates were guaranteed to stay low for 10, 15 or 20 years, then the stock market is dirt cheap now.

That said, if interest rates rise substantially, the stock market rally could be halted, Johnson said.

“Stocks and bonds compete for investors' dollars and low interest rates make stocks look more attractive versus bonds,” he said. “In fact, many blue-chip stocks have current dividend yields higher than the 10-year bond rate.

“Also, lest an investor worry about the safety of the dividend, (Johnson & Johnson) has increased its dividend for 54 consecutive years,” Johnson added. “Over the next ten years, would you rather own J&J stock or the 10-year bond?”

Of course, advisors are tuned into the fact that every client’s financial situation is unique, and that the best move may be to take the money and run.

“Personal circumstances dictate how much exposure someone should have to this market,” said William Stack, founder of Stack Financial Services in Salem, Mo. “Opportunities exist where caution abounds, and no one ever went broke from taking a profit.”

Brian O'Connell is a former Wall Street bond trader, and author of the best-selling books, The 401k Millionaire and CNBC's Guide to Creating Wealth. He's a regular contributor to major media business platforms, including CBS News, The Street.com, and Bloomberg. Brian may be contacted at [email protected]