If there's something bigger than a bull market, it just happened.
The S&P 500 officially doubled from its March 2009 lows last week. This was the fastest the index has ever doubled since its debut in the 1950s. Markets have surged 25% over the past six months alone -- essentially uninterrupted, mind you. This stuff makes the late '90s look dull.
Seems like a good a time to check on valuations.
This chart helps me put the S&P's valuation into context:
Sources: Standard & Poor's, Yahoo! Finance, author's calculations.
Markets traded at these levels in mid 2006. The S&P 500 earned $88 that year. It's forecast to earn $96 this year after pulling in $84 in 2010.
Investing in mid-2006 wasn't, of course, a brightest of moves. The market rallied over the following year, then ate dirt for the next two. The big reason markets collapsed from 2007-2009 was the financial crisis -- not high valuations per se -- but this is almost an irrelevant distinction. Investors were burned when the financial crisis hit from 2007 on because valuations didn't leave any room for the economy's inevitable hiccups. There was no margin of safety. No cushion. The best you could hope for was mediocrity. Maybe a little more, probably a lot less -- which is what happened.
Today's market is starting to look similar. On a trailing-12-months basis, the S&P trades at 16 times earnings, versus an average of about 18 over the past 23 years. Ignore the insane valuations of the late '90s, and today's valuations are probably about historically average. Use a different metric, like Yale economist Robert Shiller's cyclically adjusted PE ratio, and today's market looks somewhat above average. Balance that out with today's record low interest rates, and I'm throwing my weight behind today's market being averagely valued. Final answer. I've held out for a long while, convinced that broad markets still looked cheap. Not anymore. The facts have changed. Normal valuations are back.
What's that mean? Just what it meant in 2006. The best we can now hope for is middling long-term returns -- 5%-7% per year, something like that. That's not being pessimistic. It's just what happens when valuations rise.
But here's what should make you pessimistic: With valuations where they are, it'll get real itchy once another of the economy's inevitable hiccups rears its head. Inflation. Rising interest rates. Geopolitical tension. Foreign uprisings. Partisan clown shows. Corporate fraud. Bieber Fever. Go right down the list. When one of these events comes along, there's no cushion in stock valuations to muffle the blow like there's been over the past two years. No more margin of safety. Just you, staring capitalism in the face. That's when investors set themselves up for trouble.
This doesn't mean you should abandon stocks. It doesn't mean panic. It just means you have to get more selective. Broad markets might look hairy, but plenty of individual companies still look great. Microsoft
If inflation's got you worried, those with a strong history of pricing power, like Altria
Opportunities still exist. Just not where it's been over the past two years.
What do you think?
Fool contributor Morgan Housel owns shares of Microsoft, Johnson & Johnson, Altria, and ExxonMobil. General Motors and Microsoft are Motley Fool Inside Value selections. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of Altria Group, Exxon Mobil, and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.