DOW 17,000 Celebrate or Hibernate – While we were winding down this past Thursday and preparing to celebrate our independence, the Dow Jones Industrial Average broke through 17,000 with the S&P 500 not far behind in approaching the 2,000 level. While some are celebrating this event others are sounding the alarm. So who’s right?
Celebrators are heralding the June unemployment report as reason to cheer but this doesn’t really address the $64,000 question? Is the S&P 500 approaching the 2,000 level fairly priced, still cheap, or too expensive?
Just as the per package price of a box of chicken tells us little of its true cost without knowing the price per pound, S&P 500 levels tell us little without knowing how much earnings are being generated by the companies it represents.
To calculate the “price per pound” equivalent of the stock market we simply divide price by earnings to obtain a price to earnings (PE) ratio or multiple.
To adjust for inflationary, seasonal, and business cycle variances in price and earnings, Yale University Professor Dr. Robert Shiller developed the Cyclically Adjusted Price Earnings (CAPE) Ratio for which he received the Nobel Prize in Economics in 2013.
The CAPE ratio for the S&P 500 is currently at 26. With an average CAPE ratio of 16 for the S&P 500 over the past 143 years, todays 26 level is certainly in the expensive range.
But how expensive is the stock market with a current CAPE ratio of 26?
As you can see in the following charts, the S&P 500 has only risen above the 21 level six times in the past 143 years and each time the market experienced a significant decline in the ensuing years to come. These declines occurred for one reason and one reason only. Stock prices simply became more expensive than corporate earnings and the economy could support.
But can the stock market continue to climb higher from here? Absolutely, because although every professional on Wall Street knows the current market is expensive it will take some catalyst, or event to trigger the slide downward. Ironically, it will be this future event that will be blamed in the “Headlines” for the stock market collapse, not the simple fact that the stock market got too expensive relative to earnings.
While the CAPE index doesn’t serve as a good timing indicator for exiting or entering the stock market, it does serve as a good warning for when to be cautious.
Buy and Hold investors should study these charts closely for I trust that they will be hard pressed to find many 30, 40, or even 50 consecutive year periods where a severe market collapse would not have been devastating to ones portfolio.
These charts were prepared using stockcharts.com from CAPE Index data published on the Yale University web site. The chart below the CAPE Chart is the inflation adjusted S&P 500 index aligned over the same periods of time. (Note: These chart does not include data points prior to 1900 due to software limitations)