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Déjà vu, All Over Again? Just How “Cheap” is the Stock Market

Investors know the name of the game – “buy low, sell high”.  Sounds simple enough, right?  The real question beneath this simple construct is determining when stock prices are low and offer an attractive entry point or when they may be fully valued or even overvalued and patience should be the rule of the day.  As I write this article, the Dow Jones Transporation Average sits at roughly 14032, the highest level since 2007.  The S&P 500 Index at 1526, piercing through 1500 at the beginning of the month.  The first time it achieved this benchmark was April 2000 – the peak of the dot-com bubble.   Since that time, we have seen two peaks followed by two collapses in the market.  We have recovered from the 2008/2009 “Great  Recession” to see indices approaching a potential triple top.  Yet I consistently hear pundits argue that the market as a whole is relatively cheap at these levels.  Is this possible? Arguments may be made on both sides of the fence.  Let’s look at a few of those.

Those who view the market as underpriced have some footing on which to stand.  Our economy is slowly recovering as unemployment is gradually falling.  Inflation appears at the moment to be tame.  For the most part, companies are flooded with cash, have healthy-looking balance sheets and are showing improving earnings results.  Looking forward, the S&P 500 is trading at just 13 times anticipated earnings for the next twelve months which is slightly below historical averages.

What about the stock market compared to other investment alternatives?  The interest rate on bonds is at historic lows.  Ten year Treasury bond yields are less than 2% which barely outpaces inflation.  Cash left in bank/money market accounts pays so little that the return is negative when accounting for inflation.  With few viable alternatives, the stock market appears attractive.   This is reflected in recent inflows into mutual funds by “ordinary investors”.  It appears that the average investor may be at the point where, after years of stock market avoidance, they simply can’t take it anymore and desire to own stocks again.  Those who are bullish on the markets believe these flows can continue to push markets higher and provide upside potential to the markets.  Not all market participants feel this way however.  Thus begins the other side of the story – those who fear the market is fully valued and due for a pullback.

Many studies reveal that “average” investors have a tendency to sell at market bottoms and buy at market tops.  Their buy decisions seem to be based on their inability to handle the pain of missing out “any longer” on a major bull market after a run has been firmly in place and is closer to its end than beginning phase. Their investment can represent an inflection point in the market.  Couple this with the fact that, while the U.S. stock market appears inexpensive relative to current and forward looking earnings, these earnings have been artificially inflated by the Federal Reserve’s policy of incredibly low interest rates present since the March 2009 market bottom to the present day.

U.S. stock prices appear far less inviting when utilizing less volatile comparative measures.  Yale University finance professor Robert Schiller measures stock prices against average corporate earnings of the last decade in an attempt to smooth out shorter term fluctuations.  Using this adjusted P/E ratio, the market is now at 23 times earnings, far above the historical average of 16 times and a level usually associated with market peaks.  A final comparison can be found utilizing “Tobin’s q” named for the late economist James Tobin.  This tool compares stock prices with the theoretical cost of rebuilding those companies from the ground up and replacing all their assets.  This indicator also shows current prices to be far above historical norms.

We know that no trend lasts forever.  The bullish run that has carried the markets close to all-time highs has given traders and investors fantastic returns.  The prudent investor should evaluate the risks and rewards present in the markets at current levels to determine future investment decisions.  My opinion – tread carefully.

Karen Smith
OptionsANIMAL Instructor

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