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How Expensive Are Stocks Now?

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From around 1999 to 2001, I dabbled in a little day trading. I wasn't make many trades a day, but I probably averaged somewhere between 50 and 100 a year. It was the complete opposite of the buy and hold strategy that I largely hold today. During that era, I learned a lot about technical analysis of the stock market. With a tiny amount of pride, I can say that I forgotten most of it. Hopefully that space in my head can be used with something a little more worthwhile.

A few weeks ago, I wrote an article New Nonsensical Stock Trading Idea: Someone Else Paid A Lot More For It, where the commenter, correctly, called me out for marketing timing. I think the discussion that took place was one of the most interesting in the 6 years I've been writing Lazy Man and Money and highly recommend reading it. Today, I'd like to focus on just one small part of that conversation.

In the course of the discussion, I had made the case that I think with the Dow Jones Industrial Average (DJIA) up around 13,000 stocks looked expensive. My rational was that except for a short time in 2007 the DJIA hadn't rarely been above 13,000 and it barely crossed 14,000 before dropping and then getting hit by the banking collapse in late 2008. Clearly once again, the DJIA is getting too expensive, right?

Wrong.

I love to be proven wrong as it gives me an opportunity to learn. This is a case where I learned a lot.

Where did I go wrong? I looked at absolute numbers, like Dow 13,000, and not the math behind them.

The commenter, Jim, had pointed out that the S&P 500 was actually very cheap when you look at its price relative to its earnings. Jim showed the graph:

S&P 500 Price Earnings

where it looks like the price-to-earnings ratio is around 13, which is historically fairly low indicating that stocks in general are not expensive. However, if you were looking for a cheap time to buy into stocks, like say the beginning of 2009, when the Dow had dropped to around the 7,000 range, this chart wouldn't be very helpful.

It's at that point that I started to look into this in a little more detail. I found that there is something called the Shiller P/E (yes same Robert Schiller mentioned here: Buying a Vacation/Retirement Home (Part 5)) that is does seem to spike during these blips of historically cheap times to buy. Here's a telling chart from Multpl.com:

Schiller P/E 10 chart

That chart might be a little small, but hopefully you can make the peaks at the 1991, 2001, and 2008 market drops.

It's worth noting that the chart isn't currently screaming that it's time to buy like on the other big dips.

Using the two charts, my admitted amateur opinion is that stocks are fairy cheap, but that they aren't screaming deals that they've been a few times in the last 20+ years.

The bigger lesson here is to not look at absolute numbers. It was something that I had known for a long time, but had simply forgotten. It's a strong reminder to me that every now and again it is wise to go back to the basics.

Posted on September 11, 2012.

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5 Responses to “How Expensive Are Stocks Now?”

  1. That’s pretty much the conclusion I’ve come to. But “stocks” can be too general. I use 3 major index funds, so they all need to be evaluated separately. If you wanted to get into things like value / small caps you could have more options to choose from.

    And that offers an alternative to pure market timing, which often means choosing between stocks and cash. Instead you can adjust your allocation between the funds you use based on their value. That’s somewhat like the hedge funds that find similar assets at different prices and make a trade until they return to normal. It seems to work pretty well for them as long as the assets are indeed similar and they don’t run out of capital/equity along the way. For us it’s easier to implement a simple allocation instead of going long/short of course.

  2. Tommy Z says:

    What about the quality of those earnings you are using to calculate the market’s P/E ratio?

    Financial companies now make up a largely disproportionate share of the earnings in the S&P – and those earnings are not real, free market earnings. The only reason they have earnings is thanks to market manipulation by the Federal Reserve by keeping interest rates low.

    The big banks borrow at very low interest rates and then turn around and invest that money in “safe” government bonds that are paying slightly higher. The spread amounts to nothing more than corporate welfare. Would you invest in a stock market that depends on the charity of the government?

    I’d say that now is the time to get out and go to cash…except the government is messing with cash too. With all the money printing going on, the value of the USD is just teetering on the edge of a cliff, ready to fall as inflation consumes its purchasing power. Instead – go with real cash – gold.

  3. Contrarian says:

    Lazy – the question is not whether the markets (stocks) are expensive or cheap, the question is: Are the markets investable?

    The answer to this question should be crystal clear to anyone who looks at the arithmetic, and ignores the 24/7 talking heads in the mainstream media and propaganda sold to the Muppets (you and me) by Wall Street.

    The world has reached its maximum debt saturation level. We’ve gone from 80 trillion to 210 trillion in just the last 9yrs – debt has grown at over 12 ½ % per year while GDP growth has been just 4% per year. The world has reached its credit limit. Instead of dealing with the massive debts, governments and central bankers have been stimulating, printing, manipulating and distorting the markets in an effort to stave off the inevitable default and subsequent restructuring.

    We’ve seen unprecedented government intervention into free markets on a grand scale. The worlds financial markets have been grotesquely distorted by central bankers. We no longer have free markets (defined by no one participant having a controlling interest) – today we have manipulated markets controlled by central banks and government.

    The political class chooses what particular part of market they want to stimulate leaving speculators guessing where they [Government] is going to put the money – are they going to put it into real-estate, bonds, commodities, equities… nobody knows?

    As a result, the market is totally uninvestable. No doubt, you can speculate in this market, but you cannot invest in it.

    – Contrarian

  4. John says:

    It takes great courage to say that you were wrong. Bravo! Thank you for sharing this lesson with us . . . I’ll keep in mind that there is more to numbers than absolute numbers . . . we should compare numbers against other variables to understand their meaning.

  5. Philip Hecht says:

    Taking a look at today’s markets, you can see quite a bit of skepticism. Companies that have performed well in the past for investors have seen their share prices drop like flies. The stock market’s all time favorite for shorting companies is David Einhorn, and it seems like once he’s called out a company, then it must be time for it to fall. People like this draw big crowds and gather lots of attention as to why their analysis is on point.
    My recommendation would be to do the analysis on the company yourself. You can use other people’s recommendations, but your own analysis will decide whether or not you think that a company is overvalued or undervalued. Playing on people’s fears is one of the best ways to buy into a company that you like for a discount. Do your analysis, find your buy-in price and stick with it over the long term. At some point, the people will start to wonder why they’re running to the hills.
    I’m not too familiar with how gold, or precious metals in general are a better deal than stocks. Correct me if I’m wrong please, but don’t you have to pay for a storage fee? I believe that gold and silver also don’t pay you back in the long run with dividends or any other monetary value until you sell out. So at what point is investing in precious metals more valuable than investing in stocks? I’m going to go out on a limb here and say that higher prices in gold or precious metals is a sign of pessimism towards the economy, and with pessimism, comes even better deals with the companies that you would like to buy into. One last question… why would I buy gold when it’s at an all time high? Wouldn’t that also go against the rule of “buy low, sell high?”

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