“The stock market’s at an all-time high. There’s no way it can keep this up. We must be due for a big correction.”
With the stock market’s solid run to an all-time high recently, this is the comment I hear the most lately which is undoubtedly due to what everyone hears in the press who continues to be angry at their inability to explain it.
The underlying question then is, “are stock prices out of line and, thus, due for a big correction?”
It’s a very good question that I’ve done some research on to provide you with an educated answer.
The best way to answer this is by taking a closer look at the last two times when stock market prices reached its current level. And, while doing so, develop some very important clarity on what ultimately drives the price of a particular company or index which is earnings.
As a reference point, let’s use the S&P 500 Index since it encompasses about 80% of the publicly held common stock in America, and so offers a more complete and accurate picture than the thirty stocks in the Dow.
Let’s examine the relative valuation of the S&P 500 Index, which at the moment is priced at around 1,540, vs. the valuations during the other two times the S&P was in this price range.
The first time the market reached these levels was in March 2000. That year, the earnings of the S&P 500 Index were $56 and the dividend about $16.25. At its peak at that time, the Index was trading at just over 27 times its current-year earnings. (Please keep this very important number in your mind)
At that time, stocks were also competing with the 10-year U.S. Treasury bonds which were yielding close to 5.8% at the time.
The second time prices were where they are today was the all-time high in October 2007 when the S&P 500 reached 1,565.
That year’s earnings were $82.54 and the dividend $27.73. If you quickly do the math, you’ll see that the price of the S&P was about 19 times earnings. (As a reference point, the yield on the 10-year Treasury was around 4.5% at that time.)
Before we come to today, you can already see that the S&P was quite a bit cheaper in terms of earnings at the peak in 2007 than it had been at the top in 2000. And, that they were also somewhat more attractively priced relative to competing bond yields.
Now let’s move to March 5, 2013—the day the Dow made its new all-time high—when the S&P 500 closed just below 1,540.
The earnings of the S&P 500-Stock Index last year (not even this year when they’re higher) were over $102, and the dividend is approximately $30.44. Doing the math again demonstrates that the S&P 500 was selling at about 15 times the last year’s earnings. And, perhaps more importantly, the 10-year Treasury was yielding 1.89%.
What Does This All Tell Us?
If you’ve followed right along, you’ll see that at roughly the same price level it was 13 years ago in March 2000, the S&P 500 is selling for pretty nearly half the multiple of earnings it was then ($102 vs. $56). The dividend yield is almost twice what it was then ($30.44 vs. $16.25). And, both the earnings and the dividend compare much more favorably to bond yields than they did then.
Given this, it’s impossible to objectively argue that stock prices are expensive today relative to company earnings, and relative to bonds. And, especially compared to where they were the last two times the market peaked in the 1,500s.
Now, does this mean that prices will continue to go up? No. There’s no prediction whatsoever in this quick and dirty analysis.
I simply want to suggest, as I always do, that we draw conclusions based on fact and NOT based on what the “consensus” appears to be in the mainstream media.
My guess is that you can’t find one media outlet who has provided the quick historical perspective that I just revealed. There’s a reason for that. It doesn’t “sell”.
I hope this has been helpful. Please feel free to quote these numbers when you hear friends and family members repeat what they hear on the news every night.