~ Un-Common Sense In An Irrational World: We Challenge the Conventional WisdomTM ~
DOW 50,000 – IS THIS AN OVERVALUED MARKET?
The Dow Jones Industrial Average hit 50,000 for the first time last Friday. The Dow has been closing above 50,000 every day since then. It closed at 50,121.40 yesterday. The Dow is currently trading at a P/E Ratio of 25.42, which is high by historical standards. We estimate that P/E ratios are fairly valued in the 15 to 18 range.
The Dow Jones Industrial Average is only one index that we can use to estimate market valuation. The Standard & Poor 500 (S & P 500) is another stock index we can use. The S & P 500 is currently trading at a P/E Ratio of 29.65, also an historically high market valuation.
Advisor Perspectives, a financial publication for investment advisors, estimates that: “Based on January’s S&P 500 monthly data, the market is OVERVALUED somewhere in the range of 123% to 201%, depending on the indicator.” They go on to say that: “At the end of January, the average of the four [indicators they use] is 160%, one of the highest levels in history. For an eighth straight month, the average is more than 3 standard deviations above its historical mean, signaling an overvalued market.”
What could bring the Dow and S&P 500 indices back to more reasonable valuations? If you look at the P/E Ratio, the numerator is the price of the index; and the denominator represents the earnings for the companies in the index. So, the valuation could come down if the price of the index declines. Or, it could come down if the earnings of the companies in the index increase. Increasing earnings is largely a function of how the economy is doing. Our Forbes article, 11 Variables That Can Help Leaders Understand How The Economy Is Doing, can help you get a handle on how the economy is doing and where it is headed.
One final point – It’s important to remember that periods of over- and under-valuation in the markets can last for many years. So, use of these valuation metrics is not for short-term market predictions. Use these metrics for your long-term investment planning and expectations for long-term investment returns.