Is the Stock Market Too High?

A question that often comes up after the stock market has had a significant increase in value is: “Is the stock market price too high?” The corollary of this question may be: “Is the stock market too low, or under-priced?” Current economic data indicates that the economy grew more than expected in the second quarter. Instead of rising only about 1%, the government’s original estimate, it rose in excess of 2%. Housing start numbers came out this morning showing an increase in July over June of an estimated 50,000 (896,000 vs. 846,000). Consumers are spending more, initial job claims for last week dropped to 335,000 (the lowest since November
2007), employers added 162,000 new jobs last month, and the value of homes has increased. This is all good news, but there is some bad news, too. Retail earnings for companies like Macy’s, McDonald’s, Wal-Mart, and others that target lower- and middle-income people dropped. Manufacturing growth and factory orders are down. The Federal Reserve is indicating it is going to reduce, then eliminate, the stimulus it has been giving the economy within the next year. So how do you judge the stock market? Many say the “old ways” are out. But if the “old ways” are out, then how do you determine if this is a buying or selling opportunity? Let’s look at 
the old methods of making decisions. When we invest in stocks we are investing to capture the earnings and earning potential of a company. The price earnings ratio (P/E) is a significant way of looking at individual stocks and the broad market. It takes the price of a stock and divides it by the earnings of the stock. This gives us an understanding of how an increase or decrease in the price of a stock is determined, based on earnings of the stock. Using the S&P 500 as an example, the P/E is 18.62 vs. 15.89 a year ago, which appears to be a big increase in price vs. earnings in one year. We cannot stop at this point, because what we really want to know is how much will we earn between this year and next? The forward P/E, which looks at estimated earnings for the coming year, is 15.40, lower than the ratio was (15.89) last year. This appears to be a bullish sign for stocks because it indicates that current prices are not out of line with the norm. Another piece of information to examine is the percentage of dividends paid to the price of the stock. For the S&P 500, the current dividend rate is 2.04% vs. 2.07% a year ago, which seems to be a small dip. When we examine what is really happening, we must take into account the price gain from a year ago. If we had $100,000 in the S&P 500 one year ago, our annual dividend would be about $2,070 (2.07%). Between last year and this year our, account would have grown by 17%, the rise in the S&P 500 during the one year period. Now our account would have $117,000, earning 2.04% for an annual dividend of $2,387 or $317 more than last year. All of this indicates that, as earning on stocks have grown, the prices have risen and the companies have been paying increasing dividends. This seems to me to be a rational way to look at the stock market, even if I’m using the “old ways.”
Ed Mallon