So, the Dow Jones Industrial Average broke above 11,000 on Friday for the first time since September 2008. Just what does that mean?
If you watched the CNBC headlines, you'd think we just landed on the moon, or cured cancer. But these market milestones really mean nothing. Eleven thousand is no more important than the ten-thousand nine-hundred ninety-nine numbers that came before it.
What milestones do, however, is get investors' attention. In this case, 11,000 seems noteworthy because it's roughly where the Dow stood just before Lehman Brothers collapsed in September 2008 -- the real start of the financial crisis. On Friday, Sep. 12, 2008 -- the last trading day before Lehman collapsed -- the Dow closed at 11,421. That we're nearly back to those levels even while so much as changed since then (and not in a good way) makes investors wonder: Are stocks overvalued? Reminded that markets have surged roughly 70%-80% (depending on which index you follow) since March 2009, it's becoming ever more popular to answer yes.
My Foolish colleague Alex Dumortier uses a metric called the cyclically adjusted price-to-earnings ratio to argue, fairly convincingly, that stocks are overvalued compared with historical averages. The stretched valuations of companies like Amazon.com
But another way to put the rally into perspective is to compare the past year's surge with consensus forward-looking earnings estimates over the same period.
For now, we'll switch to the S&P 500 Average, since earnings estimates are more abundant for this index. Consider this chart, which begins on March 9, 2009, the day markets bottomed:
What this shows is pretty important, but doesn't get enough attention, so I'll write it in bold italics:
There is one thing that has surged farther and faster than stocks during most of this rally, and that's earnings estimates.
This is exactly what you want to see. That's what a healthy rally -- one built on rising profits, not expanded multiples -- should look like. In fact, if you look at the red line in the chart, showing forward-looking consensus earnings estimates, the S&P 500 is currently valued (not priced) at the same level it was in late March 2009, even though the index has since shot up some 50%. We love to marvel at the magnitude of the market's rally, but it's the surge in profit estimates -- and reported profits, too -- that has been most impressive.
Of course, you can take these forward-looking estimates with as many grains of salt as you'd like. Economists and analysts have a nasty tendency of being quite wrong. As Larry Summers, President Obama's economics advisor, famously quipped, "THERE ARE IDIOTS. Look around." Nothing is ever certain, even when highly paid people say so.
So answering "what's next?" after Dow 11,000 is wholly unknown, of course, and change the channel when someone says they do know. But I wouldn't take it as a sign that blind optimism has returned. For every sensible bearish argument, you can just as sensibly make a bullish one. Given forward-looking valuations, I'm tempted to lean toward the latter.
But I want to know what you think. How do you feel about the market? About valuations? About where we're headed next? Let 'er rip in the comments section below.
Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. Apple and Amazon.com are Motley Fool Stock Advisor recommendations. The Fool has a disclosure policy.