March 18, 2011
The ValuEngine Valuation Model tracks more than 5000 US equities, ADRs, and foreign stock which trade on US exchanges. The model calculates a level of mispricing or valuation percentage for each equity based on what the stock should be worth if the market were totally rational and efficientan academic exercise to be sure, but one which allows for useful comparisons between equities, sectors, and industries.
We track valuation figures and use them as a metric for making calls about the overall state of the market. Whenever we see levels in overvaluation levels in excess of @ 60% for the overall universe and 27.5% for the overvalued by 20% or more categories, we issue a valuation watch. When overvaluation exceeds 65%, we issue a valuation warning.
Our watches and warnings let us know that the model thinks things are overheated, but they cannot tell us when a correction will occur, nor can they tell us its duration and depth. In some cases the market heads for a long dive, in others we see juts a momentary drop before the market resumes an upward climb. We simply do not possess the long-term historical data necessary to complete a better study of the metric.
However, we did use this indicator to warn our clients of a possible correction on one other occasion. Last April, we issued our Valuation Watch within a few days of the big Spring/Summer correction. We issued a Valuation Watch with the SP 500 at 1192 on April 19, 2010. We saw an overvaluation calculation of 61.45% on April 26, 2010 with the index at 1217 and then the SP 500 slid down to 1022 by July.
We recently called off a Valuation Watch which had been in effect since December 15, 2010. We began our Valuation Watch with the SP 500 at 1241 and called it off as of last Friday with the benchmark around 1275. Over the period of this Valuation Watch, we issued Valuation Warnings whenever our overall universe overvaluation figure exceeded 64.5%. We issued a total of 14 warnings during this period.
We have certainly seen some market carnage recently. The crises in the Islamic world coupled with rising oil prices, continued uncertainties in the Euro zone, and the Tsunami aftermath in Japan are causing a flight to safety. It remains to be seen how far the slide will be this time. We will need a much longer live-tracked overvaluation data set to figure out if our Valuation Watches and Warnings are reliable indicators or just lucky correlations.
So far, we are still above the levels of December when we issued the latest Valuation Watchas of this writing the SP 500 is at 1273. However, with the exception of the period from February 2nd to February 22nd, the Valuation Warnings did provide a timely signal of a dipeven if the market did quickly shake off the wobble and power back up. We will continue to watch and track the overvaluation metric so that we may add to our dataset.
Below is a chart which tracks overvaluation our overvaluation calculations for the duration of our latest Valuation Watch. Here you can see what the market did when we issued our warnings. This is real tracked data, gathered from our website on an almost daily basis. We issued the warnings as indicated by the red columnsthese were included in our Daily and Weekly Bulletins. The overall overvaluation calculation is represented by the yellow line. The blue line is the SP 500 close.
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