This has been a rough week for the stock market as major indices such as the Dow and S&P 500 have lost 10% of their value. Although many have ascribed the drop to China problems, the underlying issue is the state of US stock markets. Conditions for a correction have existed for several months, with the fact that the market has been overpriced evidenced by a positive FEV market premium.
FEV Analytics measures the fundamental value (FEV) of each company on the S&P 500, and is able to determine the S&P 500 market premium by computing the ratio between the market value of invested capital (MVIC) and the FEV. We perform the same calculation for each major industry segment of the market.
In August 2013, in response to widespread claims that a market collapse was imminent, the research team at FEV Analytics examined the data and concluded that the market was not overpriced. Therefore, no correction was warranted. (We posted this analysis on our blog that fall).
What happens now, after the major declines over the last few days?
Many prominent experts believe the market always returns to fundamentals. Former PIMCO CEO Mohammed el-Erian summarized these views in a televised interview yesterday, Monday, August 24. In that interview, he predicted that stocks have a lot further to fall – a prediction that was based on fundamentals and which so far has proven correct.
As of market close today, the S&P 500 still carries a positive premium, i.e. is overpriced. However, our analysis suggests that the situation may be evolving. Initially, all sectors were overpriced. The most overpriced sectors (e.g. health care) prior to the correction suffered larger declines but remain overpriced, while less overpriced sectors (e.g. energy) declined less and are now approximately at their historical medians. Thus far, the correction has been broad based, but it may now evolve into a more sector-specific decline.
The Bottom Line:
The stock market is still overpriced, but there are sector differences. Based on the fundamentals, some sectors are more at risk than others. Of the nine sectors represented by SPDR ETFs, five are still significantly overpriced, four are priced at approximately their FEV value, and none are underpriced.
If you agree with those who say the market is going back to fundamentals, beware of the overpriced sectors.