In Pamplona, the annual running of the bulls ends in mid-July. On Wall Street, the event has taken on a life of its own this year, taking us through July and into August. On July 23, I wrote about the Dow Jones Industrial Average (DJIA) breaching 9,000, and only last Friday, the index hit a high for the year at 9,370.07. However, the rally appears to have run out of steam this week. Did the Dow hit a top?


Q3 Return to Aug. 7, 2009

Cyclically Adjusted P/E

Bank of America (NYSE:BAC)



General Electric (NYSE:GE)



Cisco Systems (NASDAQ:CSCO)






Pfizer (NYSE:PFE)



Wal-Mart (NYSE:WMT)



Procter & Gamble (NYSE:PG)



Source: author's calculations based on data from Capital IQ, a division of Standard & Poor's. P/E = price-to-earnings ratio.

Let me be quite clear: I can't predict whether Friday's high is a top -- only fools (small "f") and stock shills can do that. However, I can offer some thoughts on whether the Dow is reasonably priced at current levels.

Value matters
One of the most reliable indicators of value is the cyclically adjusted price-to-earnings (CAPE) ratio, which compares price to the average inflation-adjusted earnings over the prior 10 years. Designed to smooth out the effects of the business cycle, the CAPE was originally devised to analyze individual stocks by Benjamin Graham, the father of value investing. More recently, economists Andrew Smithers and Robert Shiller have popularized the use of the CAPE for valuing the U.S. stock market.

Following this methodology, I derived a CAPE data series for the Dow going back to 1940. The following table summarizes some of the results:

Dow Comparisons


DJIA (at Aug. 10, 2009)


Cyclically Adjusted P/E multiple


Average CAPE (full series: Jan. 1940 – present)


Average CAPE (April1975 - present)


Average CAPE (Dec. 1982 - present)


Source: author's calculations based on data from Dow Jones Indexes and Capital IQ, a division of Standard & Poor's.

Based on comparison of the DJIA's current multiple with the CAPE's long-term average going back to 1940, we would have to conclude that the index is about fairly valued. However, I also calculated the average starting at the month that followed the trough of the two longest historical recessions in the postwar era. By those yardsticks, the Dow remains undervalued at present (the same observation is true for the broader S&P 500 index).

Blue chips and the broader market
I could be persuaded to believe that the Dow is undervalued, which would be consistent with value maven Jeremy Grantham's assertion in his most recent quarterly letter that "the easy winner of the cheapest equity sub-category contest is still high quality U.S. blue chips."

On the broader stock market, I'm much more skeptical. My sense is that the S&P 500 is now overvalued. Investors should consider adjusting their exposure to U.S. equities accordingly and look beyond U.S. borders to international stocks.

Jeremy Grantham's firm, GMO, is forecasting that "high-quality" U.S. stocks will beat large-cap stocks by more than six percentage points annually over the next seven years! Fool contributor Morgan Housel has identified three high-quality companies that are still cheap.