Valuations: Are Stocks Overpriced? [Dow Jones Industrial Average, SPDR S&P 500 ETF Trust]

bearbull21-150x1501Chris Ciovacco: We recently examined the performance of “safe” blue-chip dividend stocks and “stable” utilities during the 2007-2009 bear market; the results may have been surprising to some. Since price-to-earnings ratios (PEs) are often used to identify favorable entry points or “overvalued” levels for stocks/indexes, the next logical question is:

Are PE ratios a good investment timing tool?

We All Want To Protect And Grow Capital

If we get down to brass tacks, the basic objective of all investors centers around this basic premise; we all want to make money and we all do not want to lose money. According to multpl.com, the S&P 500’s PE ratio was 19.69 on July 1, 2014, based on the latest reported earnings and recent market price. Having worked on Wall Street for 20 years, a PE ratio of 19.69 sounds rich, but does that mean stocks are overpriced and it is time to get out?

Missing Four Of The Greatest Years In Stock Market History

To answer that question, we will turn to historical facts. For our hypothetical historical example, we will assume the following:

  1. It is December 1, 1995, our investor is 55 years old and has been sitting on $500,000 cash waiting for the market to pull back to reach a more favorable buy zone.
  2. Our investor, who just missed a big rally in the first eleven months of 1995, finally says “I have to get invested”.
  3. The S&P 500’s PE ratio on December 1, 1995 was 18.10. Our investor decides that he will pull the investment trigger as soon as the PE ratio dips below 18. Note: The same rationale could be used in 2014.
  4. Unfortunately, waiting for stocks to reach his buy zone became an even more frustrating exercise. As shown in the table below, the S&P 500’s monthly PE never dropped below 18 between December 1, 1995 and April 1, 2000.

Stocks Can Remain Overvalued For Years

If we asked our hypothetical investor in late 1995:

What are the odds the S&P 500’s PE ratio does not dip back below 18 over the next 52 months?

Since most valuation-oriented investors believe every overvalued market is overdue for a pullback, our guess is our 1995 investor would have responded with:

The odds are almost zero that PEs will not dip back below 18 in the next 52 months.

Lost Opportunity Using PEs As Timing Tool

Investing risks include opportunity costs. We all will experience a limited number of bull markets and investment bubbles in our lifetime. How much money did our value conscious investor leave on the table? If we assume for illustrative purposes that we invested in the S&P 500 ETF (SPY) on 12/1/1995 we would have paid $43.80 per share (on an adjusted basis).

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