U.S. economy must perform in future to justify stock market valuations
August 15, 2017
The stock market has hit record levels this year. We've seen new all-time highs for the Dow Jones Industrial Average, the S&P 500, and the NASDAQ. Last week, we saw some volatility due to geopolitical tensions with North Korea, which will hopefully be short lived.
With the market near record highs, it's an interesting time to take a look at the stock market's valuation. One of the most common ways to do this is by analyzing the market's price to earnings ratio (PE). Currently, the forward PE for the S&P 500 is 17.7, which is higher than average. The five-year average is 15.4 and the 10-year average is 14.0.
The forward PE ratio is calculated by using future earnings estimates for the next year. That means the earnings growth we've been seeing this quarter will have to continue for the record bull run to keep going. Earnings growth for the second quarter has been over 9 percent.
Another useful metric for evaluating stock market valuations is known as the cyclically adjusted price to earnings ratio (CAPE). The CAPE ratio was developed by Nobel Laureate Robert Shiller, and is also commonly referred to as the Shiller PE ratio. Shiller is also well known for his work developing a real estate index known as the Case-Shiller Twenty City Index, which tracks home prices in 20 different major metropolitan areas.
Presently, the CAPE ratio is fairly high with a reading of 29.86. Since 1890, it has only been higher than this a couple of times. It hit 30 on Black Tuesday in 1929 before the Great Depression.
The highest level ever for the CAPE was a reading of 44.19 in December 1999 before the dotcom bubble burst. The average for the CAPE is 16.77; so today we are well above average.
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The difference between the forward PE ratio and the CAPE ratio is that the CAPE ratio calculation factors in the average inflation adjusted earnings from the previous 10 years. Shiller has stated that the CAPE ratio is not useful for timing crashes and short-term trades, but should be applied to try to determine longer-term returns.
The stock market is a forward-looking mechanism, which typically looks about six months ahead. The economy will have to perform well in the future to justify these valuations.
Kenneth Roberts is a Truckee-based Registered Investment Advisor. Information is at his blog at http://www.sellacalloption.com or 775-657-8065. The mention of securities should not be considered an offer to sell or solicitation to buy investments mentioned. Consult your investment professional to understand the risks and/or how the purchase or sale of these investments may be implemented to meet your investment goals. Past performance is no guarantee of future results.
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