Stock market pricing indicates whether stocks are cheap or expensive in relation to earnings. It is a poor indicator of market timing, but good at predicting long-term investment returns. High valuations warn of low investment returns over the next decade, and low valuations indicate an opportunity for above-average returns over a similar period.
Stock Pricing
US stock pricing jumped to a new high of 97.22, up from 95.72 percent last week, and compared to the recent low of 91.79 twelve weeks ago.
We use z-scores to measure each indicator’s current position relative to its historical data, with results expressed in standard deviations from the mean. We then calculate an average of the five readings and convert that to a percentile. The higher the stock market price measure is relative to the historical mean, the greater the risk of a sharp drawdown.
Buffett Indicator
Warren Buffett’s favorite long-term measure of stock market valuation provides a stable valuation ratio largely unaffected by fluctuating profit margins.
The ratio of stock market capitalization to GDP jumped to a new high of 3.31, up from 3.25 last week. The ratio is way above its long-term average of 1.2 and warns that stock pricing is dangerously high.
Dow Jones Industrials Price-to-Sales
The Price-to-Sales ratio for the Dow Jones Industrial Average rocketed to 4.57, up from 4.21 last week. However, the index composition has changed, with Alphabet Inc. (GOOGL) replacing Verizon (VZ) on June 29.
We use a 20% trimmed mean of the Price-to-Sales ratio across the 30 stocks in the Dow to remove the most extreme readings that would otherwise distort the ratio.
Dow Jones Industrials Forward PE
The Forward PE for the Dow Jones Industrial Average jumped to a new high of 22.13, up from 20.92 last week.
We use a 20% trimmed mean of the Forward PE for stocks in the Dow to mitigate the impact of outliers.
Shiller CAPE
Robert Shiller’s CAPE smoothes out business-cycle effects by comparing the S&P 500 index to a 10-year average of inflation-adjusted earnings.
The CAPE ratio retreated to 39.46, down from the recent peak of 41.33 five weeks ago. The current advance is the second-highest in history, behind only the Dotcom bubble in 1999-2000, with values far above their long-term average of 22.4.
PE of Highest Trailing Earnings
The S&P 500 Price-Earnings (PE) ratio increased to 25.4 from 25.0 last week, based on the index’s highest trailing earnings. The long-term average is 17.3.
Conclusion
The extreme pricing indicates an elevated risk of a significant drawdown.
Related Links
Acknowledgments
- Prof. Robert Shiller: CAPE 10 Data
- Federal Reserve of St Louis: FRED Data
- Morningstar: Dow Jones Industrial Average Data