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Is the Market Oversold?

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The NASDAQ, DOW Jones and S&P 500 are all experiencing record highs. But does this mean that the market is oversold and we should expect declines? Not necessarily.

Without speaking to the point of how our economy and businesses in general are going to perform moving forward, the fact that the indexes are higher is only one of many factors to consider. In truth, it is almost irrelevant. The indexes are a compilation of selected stocks, and really do not reflect whether the underlying companies, which comprise the index, are being priced at higher rates.

The pricing of most companies, particularly mature companies on the exchanges, is measured on the basis of price-earnings (PE) ratios. Hence, if a company is generating $1 per share and its stock price is $10 per share, then the PE ratio for that company is 10. The market determines the different PE ratios for different companies on an individual basis (one example being their potential for growth), but generally there are a range of PE ratios for different sectors.

For instance, the range of PE ratios in the construction sector may be 10 to 12, while for Internet companies, the range may be 20 to 25. In order to determine if companies are currently trading at higher values than compared to before the 2008 economic collapse, the most accurate way of making such an assessment is to look at the PE ratios by sector or by company in 2007, and compare those ratios to today's ratios. By doing so, one would discover that companies today are actually trading at PE ratios which are generally 30 percent less than pre-2008 figures. That would seem to indicate that stocks are generally still cheap. So why are the indexes so much higher?

The companies that comprise the relevant indexes have grown significantly. During the economic crash of 2008, weak companies were in effect eliminated -- either by going out of business, through recapitalizing or by merging into other companies. The emergent companies came out bigger and stronger in the process, and now face fewer competitors. These companies are experiencing greater earnings and more security due to their increased size, which results in an increased barrier to entry for newer competitors. In addition, capital was constrained during 2008 and thereafter, so companies in 2008 and 2009 amassed staggering amounts of cash and became much more stabilized in the process.

For many sectors, particularly the banking and financial sectors (such as insurance and the like), accounting policies became stricter and assets were written off in 2008 to levels which today are well below market value -- thereby in effect creating integral, readily available income which will be realized as the assets are released into the market. Moreover, consolidation has reduced the number of banks, thereby eliminating some competition. Additionally, their operating costs are less because offices and personnel have been reduced, and more people are conducting business online. There is generally more money in the market and therefore more capital to go around, and the banks continue to take advantage of historically low interest rates through borrowing from the Federal Reserve. And when interest rates eventually do rise, these institutions are poised to be the greatest beneficiaries of such an increase by maximizing on the resulting effect on their customers' accounts. Nevertheless, these banks and financial institutions are still trading at a value that is a fraction of what they were worth in 2007 and 2008 prior to the collapse, which means the opportunity for immense growth exists.

The indexes are comprised of these companies, and they should therefore be a reflection of said companies' improvements and growth. But the reality is that one of the most common results that has occurred is bigger companies have simply gotten bigger, while smaller companies have either gone out of business or become the product of acquisitions, having been purchased by said larger companies. This is not necessarily reflective of organic growth, but more so an indication that these companies have simply expanded. Even companies such as Google, which has grown tremendously over the years, have made several incredibly significant acquisitions which have had an immediate effect on their bottom line.

What we see occurring in the current indexes is equivalent to comparing the average value of a 2,000 square foot house in 2012 with a 3,000 square foot house today, and then surmising that because the average went up, the price also went up. But if you have a sample set where you take the price of a 2,000 square foot house two years ago, and compare it with the average price of a 3,000 square foot house today, such a comparison is simply not "apples to apples."

What we've actually experienced in this recent market surge is something much different than a recovery, and it should be recognized as such. The largest companies that have increased in size by way of other companies going out of business have benefitted greatly by securing the previously held market share of the now defunct companies. The positive impact this has had on major companies cannot be overstated. In essence, for companies to survive in today's markets, they must be massive entities capable of experiencing organic growth through regular acquisitions.

Ultimately, the crux of the matter is that because the PE ratios are much lower than they were prior to the economic collapse, companies therefore have significant room for growth. The markets are indeed higher, but this is not a reflection of an overpriced or inflated market, and savvy investors should recognize this for the opportunities that exist. In certain sectors such as finance, banking and construction, the correlating stocks are not overpriced but are, in fact, cheap.

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David Bergstein is the CEO of Cyrano Group. He is a board member of the Sheriff's Youth Foundation, an organization dedicated to providing Los Angeles County youth with safe facilities, planned programs, and the vital tools they need to thrive and succeed in life. He is founder of the Leonard and Sarah Bergstein Learning Center at the Conejo Jewish Academy.