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.

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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.