Every single day we are barraged with an array of conflicting
data about the stock market.
"Stocks are expensive," says Guru A. In the same conversation,
Guru B proclaims, "Stocks are cheap." With the S&P 500
(NYSEARCA:SPY) hitting all-time highs, do stock valuations
Using reported price-to-earnings ratios (P/E) for the trailing
twelve months is the standard method for comparing historical stock
market valuations. Advocates of this technique correctly argue that
forward earnings estimates should be ignored because they are based
upon hopeful thinking, analysts' biases, and false assumptions
rather than fact.
The current P/E ratio for the S&P 500 is around 17.81.
That's much less compared to the S&P's frothy levels of 29.41
in March 2000. It's also slightly less compared to the S&P's
19.42 P/E ratio in September 2007. Is it any wonder why the "stocks
are cheap" crowd feel so confident?
For the rest of us, there is scant evidence future stock prices
will make their next big move based upon historical valuations.
There is no light bulb in the stock market's brain that suddenly
triggers a rally because stocks are cheap. Likewise, that same
light bulb in the stock market's brain that suddenly triggers a
selloff because stocks are expensive doesn't exist.
History, for those of us who still bother with it, shows us the
stock market doesn't necessarily need to be grossly overvalued
before it can suffer a severe correction. Have we already forgotten
what occurred in 2007?
By historical standards, the U.S. stock market (NYSEARCA:VTI) in
the fall of 2007 was a bargain compared to the stock market of
2000. But that still didn't stop stocks from declining almost 50%
over the next 18 months.
Interestingly, the selling fear that gripped the 2008-09 stock
market created its own historical distortions. The disconnect
between stock prices and trailing earnings got so out of whack, the
S&P's (NYSEARCA:IVV) P/E ratio topped 123!
In retrospect, people that used historically cheap P/E ratios in
2007 as a reason to buy stocks were
badly misguided. Will the future be any different
for people who use the same rationale as their
Stock market valuations (NYSEARCA:SCHB) do matter, but emotion
and psychology (or what technicians call "market sentiment") plays
key roles in moving stock prices. This will always be the case so
long as the stock market has human participants.
It's also good reason for never exclusively using stock market
valuations as a basis for investing or not investing. The better
technique is to use valuations in conjunction with other key
fundamental and technical indicators for a more complete
Profit Strategy Newsletter
uses technical, fundamental, and sentiment analysis along with
market history and common sense to keep investors on the right side
of the market. Since the beginning of the year, 74% of our weekly
ETF picks have been winners. (through Q3 2013)
Follow us on Twittter @