Don’t look now, but the market’s overvalued. That’s probably not earth-shattering to anyone - what else would an investor expect here in the shadow of the worst recession in decades? On the other hand, one would expect those investors to learn some important lessons about valuations.

Perhaps it’s simply a lack of information that’s allowing euphoria to swell up. So, maybe a closer look at valuations will help curb the undeserved enthusiasm… and inject a dose of reality into our collective mindsets.

In other words, let’s compare some current P/E ratios to historical P/E ratios.

Simple Yet Powerful

The method to the madness here isn’t going to be complicated. All we really need to do to get a feel for how overpriced stocks are is compare the current price multiples (based on operating earnings, obviously) to historic ones. We can even break that data out into large cap, mid cap, and small cap groups.

And, just to make it easy and tangible, we’ll base our study on the data provided for some of the key iShares’ exchange-traded funds. By doing so, we’ll also get to add a value-versus-growth analysis.

In any case, the nearby table tells the tale. Operating P/E ratios for the last twelve months are mostly in the low 20’s (to as high as the 22’s) for all the major market caps and styles, with only one exception…. large cap growth. The trailing-twelve-month P/E for large cap growth stocks - the group represented by the iShares Large Cap Growth Fund (IVW) - is a mere 19.2.

How expensive is that? With no exceptions, that’s more expensive than we’ve seen the aggregate market - or any individual market cap and style - during any of the prior five years (some of which were good years, and some not so good).

History Versus the Future

Investors may argue that the past isn’t the future, and we’d fully agree… even though the recent past is frequently a helpful guide to what lies ahead.

Just to address the then/now concern though, nearby you’ll also find a table of historical and projected P/E ratios for those same market segments. The picture looks much brighter when doing so, but plausibility comes into question.

For instance, the iShares Small Cap Fund (IJR) currently boasts a twelve-month price multiple of 22.8 (the value and growth versions of the same small cap group both have comparable P/Es at this point as well). Standard & Poors says the stocks in the S&P 600 Small Cap Index are on pace to turn in a P/E of 31.6 in 2009. (Both can be right, since the timeframes are not aligned.) Yet, Standard and Poors also estimates the stocks in the S&P 600 Index are going to almost double 2009’s earnings during 2010; the forward-looking P/E is 16.94.

Whether the index at large is overvalued relative to 2010’s expectations, and/or the iShares Small Cap Fund is overvalued now, doesn’t really matter…. it’s just not likely that earnings will improve by that much; it would be the cheapest stocks have been in more than a decade if they did. Thus, the ETF is a liability. All of those funds would be a liability for that matter, with these hyper-optimistic projections in place for 2010.

Don’t Read (or Act) Too Much Into It

With all of that being said, it’s important that investors don’t make snap decisions based on the data above. None of the information here should be a shock, and we’re confident most - if not all - of you had the notion in the back of your mind anyway. This analysis just puts a framework around it.

More specifically, this information should not prompt you to bailout on every stock you own and hide your money under your mattress. Why not? Two reasons.

First, the projected earnings numbers are a moving target, and may improve a little as time wears on. In fact, we think they will improve a little as 2009 turns into 2010. That’s one of the benefits of an economic recovery - a call we made weeks ago.

On the other hand, we think stock prices have more ground to give up (by falling) than earnings projections have room to improve (by raised estimates). The two will probably meet in the middle somewhere.

Second, investors can and have rationalized continuing to buy overbought and overpriced stocks, so don’t assume the market will have to come tumbling down tomorrow just to get current P/Es in line with historical P/Es.

Oh, prices may come down a little, or a lot, quickly, or gradually. The valuations tell you the odds and show you the pressures, but valuations don’t make or lose you money - rising or falling stocks make or lose you money. That’s why we rely on charts as much if not more than valuation measures.

The Bottom Line

So what’s the ultimate point then, if the current P/Es may or may not matter?

Our take is simple… they matter more than they don’t. Unless earnings improve better than anticipated next year, an expensive market is going to mean stocks are facing a headwind until 2011 when - hopefully - the economy is stable.

In the meantime though (and this is important), select stocks can and likely will do well, even though the broad market flounders.

That was something that couldn’t be said in late 2008, when all stocks were sinking whether they deserved it or not. Conversely, since March of this year, all stocks were rising whether they deserved it or not. Now, however, the bull market is at the point where the best names are able to break away from the mediocre ones. You’ll obviously want to be a little pickier now than you were then.

As always, we’ll be offering specific stock ideas - in addition to our sector and market cap trend analysis - to help you do just that. Stay tuned on that front though, as the necessity of that info is increasing by the month.

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