The Standard and Poors' 500 has the following describing the composition of the index:
"The S&P 500® is widely regarded as the best single gauge of large cap U.S. equities. There is over USD 5.14 trillion benchmarked to the index, with index assets comprising approximately USD 1.6 trillion of this total. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization."
Even though it does not represent the entire market, but it is probably close to as best as you can get, not so because the composition is accurately representative, but because of its volume and how it is perceived. In the world of finance, how one thing is perceived matters more than what it really is, especially in valuation. After all if no one wants your painting it doesn't matter if you are Picasso, right? We will treat S&P500 as representation of the market from here on.
The valuation of an financial instrument, be it a stock, a bond or an index, based largely on two things: intrinsic value that focuses on the long term capital returns, and short term extrinsic value based on how volatile and risk factors perceived to be associated with this instrument. For the latter one, human emotion has a much larger influence on it, and also because the intrinsic value is focused on longer term, and things may very well changed over time, this human emotion part on how things are perceived becomes quite important, more important than many of the fundamental analysis, value driven investors think.
Now that we have broken up the two important category, let's examine each of them. I will attempt to focus on established methods while not too much relying on any particular models to get a balanced view. Let's start with the big picture. Where are we at now?
There is a well publicized view from presumably Warren Buffer's view of stock valuation, noted in this business insider article: Warren Buffett Once Said This Was The 'Best Single Measure' Of Stock Market Value, in which this graph is particularly interesting:
And that was in January. The market has risen much since then. so what does that tell us? Fundamentally, at least from the metrics described in the article, the market is in lofty valuation, so much so that traditional models no longer apply. Or is it? This model of representation forgets about the fact that prior to 2008, there was minimal Federal Reserve intervention, in particular the Quantitative Easing (buying bonds and asset with nothing but money printed) that we now all accustomed to. How much does that affect the valuation? If we can subtract that influence, can we get a better picture of where we may be now? From the Economist article in the link, the balance of the Fed is about $4 trillion, plus $85B-$75B per month. There has been some adjustment, and supposedly the number is being tapered down month by month. So let's put the number at $4.5T for the sake of simplicity. This number is pretty accurate according to Yahoo's news on Fed's decision to continue winding down the bond purchase, of $4.4T.
