Are Stocks Too High?

Both of the major stock market indexes have not only recovered from the financial crisis. They have proceeded to new heights.

Although the Dow Jones Industrial Average (DJINDICES: ^DJI  ) is down from its recent all-time peak, it continues to trade over the 15,000-point threshold. Meanwhile, the S&P 500 (SNPINDEX: ^GSPC  ) has, at least for the moment, settled above 1,600 points.

But far from being something to celebrate, it forces us to ask: Are stocks too high?

To appreciate why this is a concern, one need only glance at the preceding figure, which charts the daily closing price of the S&P 500 going back to 1950. There's a disturbing trend developing that consists of wild booms and busts.

First there was the dot-com bubble. Then the housing debacle. And now, at least insofar as the chart seems to suggest, we've found ourselves in yet another nearly identical situation.

The support for this proposition is twofold. In the first case, and particularly since last September, the Federal Reserve has pumped $85 billion a month into the bond markets. Doing so has driven bond prices higher and therefore, at least presumably, increased the flow of funds into equities. Once this spigot is turned off, it's widely assumed that stock prices will respond in kind.

And in the second case, there's no getting around the fact that valuations are higher than the long-run average. As of Friday, the S&P 500 was trading at 17.83 times earnings. And if you take the past 10 years into consideration, it's an even dearer 23.77 times earnings as of the middle of this month. By comparison, the average multiple since the 1880s is only 16.49 times earnings.

The one thing that can be said in favor of current equity prices, on the other hand, is that corporate earnings are increasing. As the following chart shows, corporate profits have climbed to around 11% of gross domestic product, far and away the highest level ever.

So how should you reconcile these points? I think the proper conclusion is that stocks are indeed priced too dearly. But whether you should respond is another question altogether. If you've established a consistent pattern of investing irrespective of cycles, then this shouldn't throw you off kilter.

If you have yet to do so, however, and are just now considering it, then you'd be wise to think twice before taking the plunge at today's valuations.

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Comments from our Foolish Readers

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  • Report this Comment On August 24, 2013, at 10:34 PM, Abe121 wrote:

    The two factors affecting stock prices are the easy money and the low interest rates. Once the easy money dries up stocks prices would be affected somewhat, but the bigger concern is for interest rates. If the rate jump up like in the period that preceded the housing bubble, then the cost of financing corporate debt would become expensive, and that would be a serious problem. Corporate profits have been so dependent on low interest rates and not on growing the revenues that the price per earning ratio would increase drastically in a couple of years to easily bubble values prompting a market crash. Hopefully, we would call this bubble for what it is; the Federal Reserve bubble

  • Report this Comment On August 25, 2013, at 10:51 AM, luckyagain wrote:

    Abe121 has put forth the statement that corporations are riding along on sea of cheap borrowed money. I wonder if that is true. Does anyone have a statistics about the S&P 500 borrowing as a percentage of net worth? The fact that CP (corporate profits) are at very high level would seem to lessen the need for borrowing.

  • Report this Comment On August 25, 2013, at 11:10 AM, daveandrae wrote:

    When i bought my very first 50 shares of General Electric stock in November of 2000, the stock was trading at 40 times earnings against a 6% ten year U.S.treasury.

    2,386 shares later and today, the forward p/e multiple of GE stock is now down to 13 against a 2.84% ten year U.S. treasury bond.

    2.50% vs. 6% in 2000

    7.69% vs. 2.84% in 2013

    I don't know what the stock market is going to do "next" anymore than the next guy. All i know is that at these market prices, you'd be a fool to sell out of a stock like GE and go into bonds or cash.

  • Report this Comment On August 25, 2013, at 11:38 AM, Redskins142 wrote:
  • Report this Comment On August 29, 2013, at 9:09 PM, NickD wrote:

    Just buy more it's the only way.

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