Are U.S. Stock Markets Overvalued?

Experts warn that stocks could be in for a quick decline.

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Earlier this week, the S&P 500 Index hit a four-year high, reaching a level not seen since before the recession in May 2008.

The high came from a string of unexpected good news in recent weeks. Improvements in housing numbers, payrolls, and earnings reports seemed to give investors confidence that the U.S. economic recovery might be gaining strength. There is also growing hope that Europe will act to rescue the euro zone; a strong sense that U.S. politicians will find a way to prevent the country from falling off the fiscal cliff; and relief in knowing the Bush-era tax cuts and other spending cuts are set to kick in at the end of the year.

[See Understanding the Fiscal Cliff: What It Means for Your Money.]

Other indexes are also performing well: The NASDAQ has increased by 3.6 percent this year, while the Dow Jones Industrial Average has gone up 9.7 percent.

The S&P ultimately retreated from the four-year high, but the summer rally has buoyed hopes that the worst economic news is now in the past. Even in the face of seemingly endless negatives in the spring, stocks remain resilient.

Some are questioning this resilience, however, and contend that the market is overvalued. Some analysts say that the price of stocks and the gains in the market do not accurately reflect the value of the companies that comprise the index.

For retail investors, there is great danger in an overvalued market. As stock prices continue to rise, confidence in investments grow. But if the market is truly overvalued, a crisis or a string of bad news could devalue the market quickly, erasing gains.

There are numerous methods to determine whether stock prices accurately portray companies' strength. For a single stock, the most common method is to determine the price to earnings ratio (P/E ratio), or the price of a share of the stock divided by the amount of money earned per share. For instance, imagine a stock that cost $24 per share. For every share of stock, the company earned $3. So the stock has a P/E ratio of 8.

[See Why You Should Pay Attention to Earnings.]

Generally, companies that have high P/E ratios are expecting higher earnings. A negative P/E ratio means the company is not performing well.

Determining the value of an entire stock market is a bit trickier. One way to do this is to compute the percentage of total market capitalization, or the value of the entire stock market relative to the U.S. Gross National Product. Using this method, the current market is moderately overvalued.

Another method is to use what is known as the Q ratio. It's very difficult to calculate: It takes the total value of the market and divides it by the replacement cost—the amount of money a company would have to spend to replace an asset. In this case, that would mean dividing the total value of the market by the cost of all the companies in the market. According to this ratio, the market is severely overvalued by between 29 and 38 percent.

Experts split, but urge caution. Andrew Tignanelli, president of The Financial Consulate, an investment advisory firm in Baltimore, says that from his perspective, it's difficult to determine whether the market is truly overvalued.

"It's a tough question to answer," he says. "In many ways, it's not overvalued. In other ways, the market has more opportunity to decline than to go up."

According to Tignanelli, uncertainty in all areas of the market, including continuing troubles in Europe, Japan, and the United States, make him wary of a quick fall. "If you ask me what's the risk-reward ratio of the market, I think there's far greater risk of downside of 40 to 50 percent or more than it is for the market to go 10, 20, or 30 percent higher," he says.

[See How to Tell if the Market is Worth the Price.]

Lisa Kirchenbauer, president of Omega Wealth Management in Arlington, Va., says the European crisis causes her the most concern when evaluating market value. The impact of deterioration there is unknown, she says, but any turn for the worse would not be good for the U.S. economy.