Friday’s expiration-enhanced dance to the downside, which came on the heels of the Thursday’s Fed-induced reversal, left investors wondering if the market wasn’t ready to roll over and retest the recent lows again. The bears could be heard telling anyone willing to listen that since the “V-Bottom” has failed to materialize this time around, a more protracted bottoming process should be expected and that a series of rallies and retests would be the norm in the coming months.

The type of discouraging action seen on Friday also begs the question, is it over? Until the market reversed after the Fed announcement on Thursday, those in the bull camp had been fairly pleased with the movement seen in stocks over the past couple of weeks and our heroes in horns argued that stocks were in rally mode. But then the action suddenly became very weak again. Ughh.

S&P 500 – Daily

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One of the best ways to determine if the recent correction has run its course is to do a check of the valuation indicators. You see, what is oftentimes lost in the emotion of a waterfall decline is the fact that lower prices have a tendency to “cure” overvaluation issues.

All Better Now?

Cutting to the chase, the answer to the question of whether or not the 11.2% decline seen in August “fixed” the valuation issues facing the stock market is, no.

For more detail, let’s run down the traditional valuation indicators:

Price-to-Earnings Ratio (P/E): While there are many ways to look at the traditional price-to-earnings ratio, we prefer to review the median P/E of the S&P 500 relative to its history from the post WWII era. And although this reading has retreated a bit from its recent high in the 22 zone, August’s level of 20.8 is still well above historical average of 16.8 and nearly double the “undervalued” level of around 12. In fact, the current reading is higher than any time prior to the “bubble period” that began in the late 1990’s. And yes, that includes the reading seen prior to the 1987 crash event. Thus, it is easy to say that stocks remain overvalued from a P/E perspective.

Price-to-Dividend Ratio (P/D): The same story applies to the P/D ratio as the current reading is indeed lower than it was a couple months back and the decline in the ratio created by the pullback in stock prices was not significant. In addition, the current reading of 47.25 on the S&P’s P/D remains WELL above ANY level seen prior to the bubble period. For example, the P/D was around 37 prior to the 1987 crash and hovered around 35 during the mid-1970’s. And with the 50-year average at 39.9, it is hard to argue that the current reading is undervalued. So, again, the P/D suggests stocks remain expensive.

Price-to-Book Value Ratio (P/B): It is essentially the exact same story when looking at the price-to-book value indicators. While the ratio has pulled back a bit, the current level is definitely elevated compared to historical readings and well above the levels seen in 1987. The good news is that the P/B has pulled back close to the average reading seen since 1978. But, once again, you cannot say that valuations are now “fixed.”

Other Price-to-XXX Ratios: In looking at other absolute valuation indicators such as price-to-sales and price-to-cash flow, the song remains the same. In short, while the indicators have seen “some” improvement, the levels remain elevated and are above all other readings seen prior to 2000. So, again…

Relative Valuation Indicators: However, when comparing the valuation of the S&P 500 to the “relative” valuation indicators, which look at current pricing relative to interest rates, stocks remain undervalued. In other words, there are really no strong alternative investments that produce a yield at this time.

The Bottom Line

The key takeaway here is that the recent correction has NOT cured the market’s valuation issues from a big-picture standpoint. However, as has been the case for some time now, stocks remain a decent play from a relative valuation perspective.

In addition, the argument CAN be made that the market did become oversold enough and sentiment did become negative enough to justify a meaningful rally. Thus, if one looks at the calendar, they can argue that as long as the “bottoming process” doesn’t turn into another leg lower during the seasonally weak September/October period, then investors might see the traditional year-end rally unfold into the end of the year.

But, it is important to recognize that short of a big improvement in earnings or a much larger price decline, the upside likely remains limited due to absolute valuation issues. And as such, some caution continues to be warranted.