Back to basics: Is this market is overvalued?

There has been a recent continuing controversy about the usefulness of forward P/E as a valuation tool in the current recessionary environment. On one hand, past bear markets have typically bottomed out at a forward P/E ratio of 10, with a low of 7 (1982) and a high of 14 (2002). FactSet's reported market rating of 21.5 forward earnings is very stretched by historical standards.

On the other hand, Liz Ann Sonders at Charles Schwab observed that stock prices and earnings estimates have shown a correlation of over 0.90 in the last 20 years and the recent correlation is a mirror image -0.90 as stock prices rose and earnings estimates fell. She then qualified that analysis by allowing the same negative correlation occurred during the GFC.

Do forward P/E ratios matter at this stage of the cycle? Is the market forward looking and discounting the current weakness and valuing the market at its "intrinsic value"? To answer those questions, let's get back to basics by considering the drivers of equity valuation.

The full post can be found here.