By Andrew Willms, President & CEO
It comes as news to just about no one that the stock market has been on a tear as of late. At the close of trading on Friday, The Nasdaq, S&P 500 and the Dow were at or near their all-time highs. Do record-high stock prices mean that the market is due for a correction? In short, not necessarily.
U.S. stocks are expensive by just about any measure. For example, as of the market close on August 14, the price-earnings (or PE) ratio of the S&P 500, which divides the current market price of the index by the reported earnings of the member companies for the trailing twelve months, was 28.99, as compared to a historic average of 15.81.
Clearly, the market’s current PE ratio has been inflated because the denominator (corporate profits) has shrunk as a result of the coronavirus pandemic. As a result, a better measure of how expensive stocks have gotten might be the cyclically adjusted price-to-earnings ratio, commonly known as CAPE ratio. That measurement restates current profits as a 10-year average of trailing earnings per share, adjusted for inflation. On August 14, that ratio stood at 31.2 as compared to its recent 20-year average of 25.7.
High stock prices are not just limited to U.S. stocks. Global stock markets are now worth more than 100% of the world's gross domestic product (GDP) for the first time since 2018. According to the so-called Buffet indicator, stock markets are considered to be overvalued when the ratio of stock market capitalization to GDP rises above 100%.
High valuations for equities have led some market commentators and analysts alike to suggest that stock prices may have peaked, and have go nowhere but down from here. They point to the fact that for the CAPE were to return to 25, the S&P would have to drop to around 2950, which would amount to a decline of about 12.5% from the close this past Friday.
That said, even an expensive market can go higher. Moreover, periods of high valuations can last for many years. But as the forgoing table suggests, the potential upside decreases, and the potential downside increases, as valuations rise.
Source: A WealthofCommonSense.com
Given all that, what should an investor do now that equity prices seem inflated? As is typically the case when it comes to investing, the answer depends on what your investment objectives are. If your focus is risk management, then lowering your exposure to equities may make sense.
If, on the other hand, you can tolerate large swings in the value of your portfolio, and you plan to remain invested for the long term (5 years or more), then you have less to fear from high equity prices. In that case staying the course could make a lot of sense, provided you are prepared to hold on fast if the seas get rough.
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