Is the Stock Market Overvalued?

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I am often asked how I determine whether the stock market is going to go up or go down during the next few weeks or months. No one knows for sure which direction the stock market is going to take, because there are too many variables that influence the stock market, and unforeseen events can negate the best research and analysis.

While I cannot predict what the stock market will do next, I know I can enhance my investment performance if I invest more conservatively when the stock market is high, and aggressively take advantage of bargains when the stock market is low. This, of course, raises the question: How do we gauge what is high and what is low?

Some investors are capable of assessing the market's current status by studying charts. I prefer to determine whether the stock market is overvalued or undervalued by "running the numbers." Any investor can determine whether the stock market is reasonably valued. The trick is to determine when the market is overvalued or undervalued.

I start by calculating a few ratios. The price-to-earnings ratio (P/E) is simple. First, I add up the prices of all 30 of the Dow Jones stocks. Then I add up all of the earnings per share ( EPS ). Finally, I divide the total prices by the total EPS to find the P/E. To determine the EPS, I use the past two quarters and estimates for the next two quarters. The current P/E is 14.7. The historic P/E for the Dow Jones Industrial Average for the past 10 years is 14.0. Therefore, I can conclude that the current stock market as measured by the P/E for the Dow is slightly overvalued at 14.7 today compared to the historic average of 14.0.

But I don't depend on a simple P/E calculation to gauge whether the stock market is overvalued or undervalued. I also compare current and historic ratios for price-to-cash flow, price-to-book value, and dividend yield. Right now, the Dow is slightly overvalued according to price-to-earnings and price-to-cash flow ratios, but slightly undervalued according to price-to-book value and dividend yield ratios. I conclude that the market is just about where it should be right now.

What about the future? By using some forecasting tools and formulas I developed, I calculate the overvalue and undervalue range for the Dow Jones for the next two years will be 14,504 and 9,615. Notice I didn't predict that the Dow will reach either extreme, but if I had to guess, I would predict that the average will stay in the mid to low part of the range.

As I mentioned in the beginning, I want to know if the market is overvalued or undervalued so that I can invest cautiously when the market is high, and take advantage of bargains when the market is low. I advise using some caution, but as a long-term investor, you should expect higher prices and continue to follow your system.

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The 2011 North American International Auto Show is underway in Detroit this week, and the publicity seems to be all positive. The event will showcase 40 new vehicles manufactured by companies from around the world. I'm not interested in buying a new car, but I enjoy seeing the fancy new cars and eco-friendly smaller cars.

Automakers are expecting to sell about 12% more cars and light trucks in 2011 compared to a solid year in 2010. There will be many new hybrid and electric vehicles and sedans, crossovers, and SUVs with more fuel-efficient combustion engines, including several new models from China.

With the average age of cars and trucks on the road today in the U.S. at more than 10 years old, Americans will need to replace their aging vehicles. Low financing rates and wider credit availability will help push new-vehicle sales higher. Noticeably better fuel efficiency as well as new hybrid and electric vehicles will also attract buyers as fuel prices continue to climb.

How can investors take advantage of the improved outlook for car and truck sales? There are three companies in the automotive sector that I really like: Ford is a U.S. manufacturer of cars and trucks. Magna International is a Canadian maker of automotive components and vehicle systems. Tata Motors is India's leading automotive manufacturer.

Ford Motor ( F )
produces cars and trucks. The company and its subsidiaries also engage in other businesses, including manufacturing automotive components and systems. It also finances and rents vehicles and equipment. Ford lost more than $7.1 billion in 2008, but has recovered remarkably without borrowing from the U.S. government.

Ford has a very heavy debt load of $117 billion, although the company also holds a high cash balance of $40 billion. The company will likely earn $1.90 per share in 2010 and $2.05 in 2011 while sales rise substantially. With the leveraged balance sheet, EPS could increase more than forecast, too. The company is cutting back the number of models that it makes, which will save manufacturing costs. New model changes and the company's international consolidation endeavors bode well for increased market share and cost efficiency. Ford does not pay a dividend now, but probably will reinstate a small dividend within the next couple of years.

Magna International 'A' ( MGA )
is headquartered in Aurora, Ontario. Magna designs and manufactures a diversified line of automotive components and vehicle systems for automakers throughout the world. The company is gaining significant market share because of its manufacturing flexibility, dependability, and geographic reach.

Automotive manufacturers are opting to outsource part of their operations to a few large component and system makers like Magna rather than outsource to many small component makers. The outsourcing trend is helping the company to expand rapidly and garner a larger share of the market.

Sales likely increased 37% in 2010 and could increase another 12% in 2011. Earnings improved from a deficit of $1.34 per share to a profit of $4.20 per share in 2011 and another profit of $5.00 in 2011. At 14.6 times our 2011 EPS forecast, MGA shares are quite reasonably priced. The company recently raised its dividend, which now yields 1.2%.

Tata Motors ( TTM )
is India's leading automotive manufacturer, but also produces buses and tractor-trailers. The company took a big gamble when it purchased Jaguar/Land Rover two years ago. Investors dumped TTM shares knowing that Jaguar would bring substantial deficits to Tata. But the deficits didn't last long, because Tata turned Jaguar around quickly.

For the 12 months ended 9/30/10, Tata's earnings increased from a deficit of $2.16 per share to a profit of $3.31 per share.  We expect forward 12-month EPS of 3.50 with future profitable years almost assured. Sales increased an impressive 58% during the past 12 months from a year ago. The company's Nano mini-car is a big hit, and Jaguar sales are soaring. At 7.7 times our forward 12-month EPS estimate, TTM shares are clearly undervalued. The company pays an annual dividend yielding 1.2%.

Tata's balance sheet is heavy with debt, but the company's much improved cash flow should allow a quick pay-down of long- and short-term debt. In addition, the company raised $750 million in a secondary stock offering, which will be used to help lower its debt. The company is in a cyclical industry, and the volatile share price swings are not for the faint of heart, but I recommend buying TTM shares at the current price.

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Investing is a serious business. We are investing our life's savings, saving for college expenses and retirement, and putting money away for many other important life events. Just as serious, though, is our state of mind toward each other and toward the world we live in. The tragic events in Tucson, Arizona, re-emphasize what can go wrong when anger and misconceptions collide.

There has been a lot of rhetoric placing the blame on the angry and inflammatory speeches of politicians, news media, and others. But aren't we all to blame? We can all surely begin to set better examples for our children, friends, co-workers and even strangers.

Six months ago, I spoke at my son's funeral during the saddest week of my life. I emphasized that he was a very kind young man, very positive in life, and a true friend to everyone in attendance. As the large gathering was about to leave, I asked every person to set goals to be kind to one another and to make every effort to become better friends. My son set a great example for his friends. Now I ask you to be kind, friendly, and to make this a better world in which to live.

Sincerely,

J. Royden Ward
For Cabot Wealth Advisory

Editor's Note: You can find additional stocks selling at bargain prices in the Cabot Benjamin Graham Value Letter. In every issue, you'll find my legendary Maximum Buy and Minimum Sell Prices for over 250 stocks. Click here to get started today!



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

Referenced Stocks: EPS , F , MGA , TTM

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