How to spot an overheated market
We are having a very nice run in the Dow Jones Industrial Average. The Dow has finally closed above 13,000. It was last at that point in 2008. Has the market gotten too frothy?
THE SHORT ANSWER
No. The market is still fairly valued and even under-valued.
THE LONG ANSWER
You are probably familiar with the P/E ratio. It is a gauge of value for stocks and stock markets based on share price and earnings. The lower the P/E, the cheaper the market is. The higher, the pricier.
According to The Wall Street Journal, both the Dow and the S&P 500 are at about a 12 to 13 P/E ratio. This rough number is taking into account the past 12 month’s earnings and the next 12 months’ earnings estimates.
Why is this important? We can use the past as a simple comparison. Transamerica Financial states that the market P/E has averaged 15.6 from 1926 to 2010.
A market like we have now would be considered under-valued since the P/E is below this historic number. It looks even cheaper when compared to the 44 P/E level we saw in December of 1999.
BEWARE THE BEAR AROUND THE CORNER
Some investors will be scared out of this market because it has gone up, fearing a new downturn. Well, there is always a new downturn for the market coming soon. That is the nature of the stock market. It is volatile. The majority of the time it is flat or down and always risky. Financial writers Zvi Bodie and Rachelle Taqqu said in a recent article, “The truth is that stocks are risky no matter how long you hold them.” Only a fraction of the time is the market generating “new wealth”, or reaching new highs.
PERILS OF MARKET TIMING
The temptation in this market is to “sell at the top.” Since the market mainly dips around in volatility, we might sell and see the market drop. This creates a false sense of confidence that we can accurately time the market. I have never heard of any investor that can perfectly time the market for long periods, such as years or decades.
What happens when the market is in the “new wealth creating” phase and we are in cash? Those investors lose growth or buy back in extremely high.
IS IT TIME TO BUY?
Since we know that the market is usually not making new highs, an investor might want to consider buying more stock during the inevitable stumble. If not, the market is still cheap by historic standards. New investments now are still at fair prices.
Consider the SPDR Dow Jones Industrial Average Fund (symbol: DIA). This fund has a current annual income of 2.34 percent. This income is better than a 10-year government bond, yielding only two percent. Also, the stock fund can grow in value and grow the dividend income.