Can the Market Keep Rising?

On Friday, the Dow Jones Industrial Average index closed at a one-year high of 9,864.94 -- 51% above its March 9 low -- and the broader S&P 500 index closed just shy of its 52-week high. This furious rise has sparked intense debate between bulls and bears on whether current prices are justified, and whether the rally can be sustained.

There's no substitute for valuation
Based on the cyclically adjusted price-to-earnings ratios (calculated using average inflation-adjusted earnings over the prior 10 years), the blue-chip Dow appears to be marginally overvalued -- certainly less so than the S&P 500:

Index (Segment)

Index Level (Oct. 9, 2009)

 Cyclically Adjusted P/E (CAPE)

CAPE Long-Term Historical Average

Overvaluation

Dow Jones Industrial Average (Megacap)

9,864.94

19.1

17.7

8%

S&P 500 (Broad Market/ Large Cap)

1,071.49

19.0

16.3

16%

Source: Author's calculations based on data from Dow Jones and Robert Shiller.

However, while the CAPE is one of the very few consistently predictive indicators of long-term performance, it's unreliable when it comes to short-term performance. (If you know an indicator that isn't, I'm listening.) In that regard, there is no saying that this rally can't continue until the end of the year, or even beyond.

Risk remains to the downside
Nonetheless, the risk for broadly diversified equity investors (e.g. SDPR S&P 500 ETF (NYSE: SPY  ) shareholders) is higher in the short term, as well. Combine greater overvaluation with a higher degree of uncertainty concerning the third-quarter earnings of its components, and the S&P 500 looks more "combustible." Take a look at the big Dow Jones names (that are also part of the S&P 500) reporting this week:

Company

Reporting Day (Week of 10/12)

Volatility of EPS Estimates*

Intel (Nasdaq: INTC  )

Tuesday

5.1%

Johnson & Johnson (NYSE: JNJ  )

Tuesday

2.6%

JPMorgan Chase (NYSE: JPM  )

Wednesday

10.4%

IBM (NYSE: IBM  )

Thursday

1.7%

Bank of America (NYSE: BAC  )

Friday

202.3%

General Electric (NYSE: GE  )

Friday

11.1%

*As measured by standard deviation of Q3 EPS/ consensus Q3 EPS (in absolute value).
Source: Author's calculations based on data from Capital IQ, a division of Standard & Poor's.

As the above table shows, one-fifth of the Dow's components will report earnings this week -- including its two largest financials. I've been banging the "quality stocks" drum for some time now -- this week could be a test of how bumpy the ride to long-term outperformance can be.

 Morgan Housel has identified three high-quality companies that are still cheap.

Quality matters. The team at Motley Fool Inside Value can show you how to build and manage a portfolio of high-quality company stocks trading at reasonable prices. To find out their top five recommendations for new money now, take advantage of a 30-day free trial today.

Fool contributor Alex Dumortier, CFA has no beneficial interest in any of the companies mentioned in this article. Try any of our Foolish newsletters today, free for 30 days. Intel is a Motley Fool Inside Value recommendation. Johnson & Johnson is a Motley Fool Income Investor recommendation. The Motley Fool has a disclosure policy.


Read/Post Comments (3) | Recommend This Article (10)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 12, 2009, at 6:32 PM, dudemonkey wrote:

    Sure it can keep rising, and it probably will. People holding strong currencies can buy more shares of US companies today than they could nine months ago.

  • Report this Comment On October 12, 2009, at 6:56 PM, guiron wrote:

    It can keep rising on a weaker dollar, but question then becomes, how long can the dollar drop?

    It looks like the dollar index is bouncing along the 76 level, but I'm guessing we may see down to 72 and then a dollar rally.

    The traders own most of these moves we've seen lately, trading up on lighter and lighter volume, while A/D levels show potential trouble ahead. I think the traders want to find the resistance for the dollar bottoming out, but not really sure if we're there at the moment. Oil can't really go much higher, and we already had a pretty strong commodities rally as well as good earnings on cost cutting. We need a rise in the dollar to pull this back a bit, but if the dollar starts to gain on bad news going into earnings season, watch out below. Until then, we'll keep climbing the wall.

  • Report this Comment On October 13, 2009, at 9:48 AM, stanton17 wrote:

    Quite a bit of cash sitting on the sidelines waiting for the right moment to "get back in"...

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