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 declined to 95.82% from its high of 96.66% two weeks ago and the recent low of 91.79% eight 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
The ratio of stock market capitalization to GDP retreated to 3.16 from its high of 3.24 last week, well above its long-term average of 1.2. Warren Buffett’s favorite long-term measure of stock market valuation provides a stable ratio largely unaffected by fluctuating profit margins.
Dow Jones Industrials Price-to-Sales
The Price-to-Sales ratio for the Dow Jones Industrial Average eased to 4.15 from 4.20 two weeks ago. 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, at 21.33, is 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 ratio retreated to 39.80 from its peak of 41.33 last week. 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. CAPE smoothes out business-cycle effects by comparing the S&P 500 index to a 10-year average of inflation-adjusted earnings.
PE of Highest Trailing Earnings
The S&P 500 Price-Earnings (PE) ratio fell to 25.2 from 27.3 last week, relative to the highest trailing earnings. The ratio remains high compared to its long-term average of 17.3.
Conclusion
The extreme pricing indicates high 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