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Opinions on stock market valuations flow easily around Wall Street, too often without backing.
Looking at the typical measurement used to determine stock valuations, I'm increasingly cautious.
Indeed, some of the numbers are downright scary just now, both in nominal value and in terms of red-light factors blinking on the horizon.
When you put it all together, here are some of my concerns about our hard-earned gains, and what we can do to profit…
Market Conditions Today Echo 1999-2000
Overvaluation measures are emitting early warning signs that we can heed now.
The S&P 500 is trading at 18.5x forward earnings, above the historical average of about 16.5x. The Shiller cyclically adjusted P/E ratio is currently about 26x the historical average of 16x. One popular measure used by bulls to justify current valuations and to deny that stocks are overvalued is to compare today's prices to those at the market peak in 1999-2000 during the Internet bubble.
Recently, MarketWatch columnist Brett Arends published a report suggesting that today's market is actually just as expensive as it was in 1999-2000. The dot-com era was notable for ridiculous valuations for companies that had no revenues or earnings.
Still,the overvaluations hit a limited number of large-cap growth stocks that rose with the tide especially hard, such as Microsoft Corp. (Nasdaq: MSFT), Cisco Systems, Inc. (Nasdaq: CSCO), Intel Corp. (Nasdaq: INTC). The rest of the market was not as overvalued. The median valuation for the top 1500 stocks by market cap today is actually higher than it was in 1999-2000, according to Mr. Arends:
- Median P/E today is 20x compared to 16x in January 2000.
- Median Price/Book today is 2.5x compared to 2.2x in January 2000.
- Median Price/Revenue today is 1.8s versus 1.4x in January 2000.
There are aspects of the markets that point to better valuations today. Dividend yields are higher today (1.3%) than in January 2000 (0.8%), partly due to the lower tax rate on dividends that now exist. And the earnings yield of the S&P 500 is 6.8% today versus 2.5% back then. But earnings today remain at record levels as a share of GDP, and these have normally mean-reverted. With earnings flattered by record low interest rates, low effective tax rates, and high levels of stock buybacks (which are occurring, in case nobody noticed, at pretty high stock prices), the likelihood of conditions continuing to support high stock prices should, at the very least, be questioned.
Understand the Risks, and Profit
The real question is whether high stock valuations are justified today in view of the significant risks that are staring stocks in the face.