Is the stock market too high? That’s one of the most frequently asked questions of financial advisors, according to JP Morgan Funds’ LinkedIn post. Valuations, market sentiment, and the fact that stocks have rallied so long without a correction pose warning signs the stock market is due for a correction. But given investors’ other options (or lack thereof) in an era of nearly zilch interest rates, the stock market may still be a bargain.
Expensive Relative to Foreign Stock Markets
The SP 500, tracked by SPDR SP 500 ETF (SPY), trades at 20.6 times trailing 12-month earnings versus a historical average of 15.5, according to Multpl.com. It trades at 18.6 times forward earnings. The U.S. stock market is much more expensive than foreign stocks. Foreign developed markets, as tracked by iShares MSCI EAFE Index (EFA), trades at 17.6 times forward earnings. Vanguard FTSE Emerging Markets ETF (VWO) trades at 14 times forward earnings.
“Anyone getting into the stock market now is setting themselves up for a lot of pain,” says Tony Hellenbrand. He’s a retirement planner and wealth advisor at Hellenbrand Financial in Green Bay, Wis., overseeing $25 million. “Now is a good time to build up dry powder in cash and cash equivalents.”
The fair value forward P/E for the SP 500 is 18.3, according to Credit Suisse’s analysts. “However, market peaks have occurred historically when the P/E has reached 23 times on average, which would imply 40% upside from the current SP 500 12-month forward P/E,” they wrote in an equity research report released June 11.
The four prior bull markets lasted 18.5 years and rallied 380% on average while the current one that started in March 2009 is only six years old with a 152% gain, Credit Suisse noted.
Shiller P/E Ratio
The SP is changing hands at a much more expensive valuation when measured by the Shiller P/E Ratio. Robert Shiller, a Nobel laureate and Yale University economist, created the ratio that’s also known as the Cyclically Adjusted Price Earnings Ratio (CAPE). It calculates the P/E ratio using the 10-year average of inflation-adjusted earnings as the denominator and current price in the numerator.
The SP 500’s current Shiller P/E Ratio is 27, far above its historical average of 16.6. It is at its highest level since October 2007 when the SP peaked before the financial crisis. The current Shiller P/E Ratio has equated to an average return in the market of about 2% per year for the following 10 years, says Bob Phillips, managing principal at Spectrum Management Group in Indianapolis, overseeing $500 million in assets.
“But you have to adjust all valuation measures for current extremely low-interest rates,” Phillips said. “When you do so you can make a good case that the market is somewhat undervalued.”
Weak Earnings Growth and Dividend Payouts