Stock market pricing indicates whether stocks are cheap or expensive in relation to earnings, but it is a poor indicator of market timing. High market valuations should not be taken as a sell signal. “Markets can remain irrational for longer than you or I can remain solvent” John Maynard Keynes is purported to have said. However, we advise caution if you are considering new positions or adding to existing positions when stock prices are high.
Stock Pricing
US stock pricing increased to 96.05 from 95.82 percent last week, compared to its high of 96.66% three weeks ago and the recent low of 91.79% nine 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 increased to 3.19 from 3.16, approaching its recent high of 3.24 two weeks ago, and well above its long-term average of 1.2.
Dow Jones Industrials Price-to-Sales
The Price-to-Sales ratio for the Dow Jones Industrial Average increased to 4.20 from 4.15 last week. We use a 20% trimmed mean of the Price-to-Sales ratio across the 30 Dow stocks 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 declined to 21.28 from 21.33 last week, but remains close to its 2020 high of 21.48. We use a 20% trimmed mean of 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 improved to 39.94 from 39.80 last week, still below its recent peak of 41.33 from two weeks ago. The recent peak was the second-highest in history, behind the Dotcom bubble in 1999-2000, and values are far above the long-term average of 22.4.
PE of Highest Trailing Earnings
The S&P 500 Price-Earnings (PE) ratio, relative to the highest trailing earnings, increased to 25.3 from 25.2 last week. The ratio remains high compared to its long-term average of 17.3.
Conclusion
The extreme pricing indicates elevated risk of a significant drawdown.
Acknowledgments
- Prof. Robert Shiller: CAPE 10 Data
- Federal Reserve of St Louis: FRED Data
- Morningstar: Dow Jones Industrial Average Data