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Are Stocks Cheap?
by David Stanowski
30 August 2007


Even though I know that most of the people, who give stock-market commentary on CNBC, have a vested interest in pretending that stocks are ALWAYS in a bull market, I still find it incredible to hear them state, day after day, that "stocks are a bargain at these levels", "stocks are cheap", and/or "stocks are a great value". Using time-tested methods of valuation shows that stocks are still anything but cheap, they are very expensive!

The classic way to compare today's stock prices with levels of known value is to compute a P/E ratio. Anyone that regularly reads investment articles knows that investors always look to invest their money in things with low P/E ratios, because it represents how many dollars that they have to pay to receive one dollar in earnings. Speculators ignore high P/E ratios, because they are betting on price appreciation instead of looking for income. However, when prices stall in their upward movement, speculators usually bail out, and prices collapse to levels that bring the P/Es in line with historical norms.

Looking back at over 100 years of data for the Dow Jones Industrial Average (DJIA), it is clear that stocks become over valued, i.e. too expensive, when their P/E ratios exceed 21. These lofty P/E ratios represent major tops, and prices fall from there until P/E ratios return to the long-term average of 14, and then continue beyond that to a level where they are under valued, i.e. cheap, around 7.

The following graph shows that the 1901 top was formed at a P/E ratio of 25, which resulted in a 20-year bear market that finally bottomed in 1921 at a P/E ratio of 5.

The 1929 top was formed at a P/E ratio of 32.6, which resulted in a 3-year bear market that bottomed in 1932 at a P/E ratio of 5.

The 1966 top was formed at a P/E ratio of 24.1, which resulted in a 16-year bear market that bottomed in 1982 at a P/E ratio of 6.6.

The 2000 top was formed at a P/E ratio of 44.2; 38% higher than at the top in 1929!! Currently, the P/E ratio stands at 20, which is hardly cheap!! It is still at a level that has formed some previous tops!

History has shown that after a major top, a multi-year bear market should take prices back to a P/E ratio of 5-7 again, in order to work off the excesses of the previous bull market. This means that the DJIA should eventually drop to 3,500-4,000. That's when stocks will be cheap again! 

Click for larger imageDJIA P/E Ratio

To get a further sense of how P/E ratios measure over and under valuations, note that when the market peaked in 2000, the DJIA P/E ratio was 44.2, and it dropped 36%, from 2000 to 2002. The NASDAQ P/E ratio reached an incredible 264 at that peak, and it dropped 78%, from 2000 to 2002.

NASDAQ P/E Ratio


The Dividend Yield is another way to measure values in the stock market. This is the total dollar amount of the dividends paid on the DJIA stocks divided by the value of the DJIA.

Looking back at over 100 years of data for the DJIA, it is clear that stocks become over valued, i.e. too expensive, when their Dividend Yields are less than 4%. These low Dividend Yields represent major tops, and prices fall from there until Dividend Yields return to the long-term average of 6%, and then continue beyond that to a level where they are under valued, i.e. cheap, around 8-10%.

The 1929 top was formed at a DY of 3.5%, which resulted in a 3-year bear market that bottomed in 1932 at a DY of 17%.

The 1966 top was formed at a DY of 3.5%, which resulted in a 16-year bear market that bottomed in 1982 at a DY of 8%.

The 2000 top was formed at a DY of 1.2%; 66% lower than the top in 1929!! Currently, the DY stands at 2.5%, which is hardly cheap!! It is still beyond the level that formed the 1929 and 1966 tops!

History has shown that after a major top, a multi-year bear market should take prices back to a DY of about 10%, in order to work off the excesses of the previous bull market. This means that, by this measure, the DJIA should eventually drop to 3,500-4,000. That's when stocks will be cheap again! 



Stock-Market-Mutual-Funds Cash Holdings are a relatively new method to get a sense of stock market valuations. This indicator has "only" been around since 1965, but it has clearly shown that when stock-market-mutual-fund managers are bullish, they reduce the percentage of their funds that they are holding in cash, and visa versa.

At major tops, cash levels have been around 4%. At major bottoms, they have been 10-12%. At the 2000 top,
stock-market-mutual-fund managers were holding 4% cash. However, they recently reduced their cash holdings to an all-time low of 3.6%. This indicator carries the same message as the other two; stocks are very expensive at the present time!


Finally, when examining a graph of the DJIA (red) versus its 36-month Moving Average (green), which acts as a measure of long-term value, it is clear that, by this measure, the DJIA has been in a persistent state of over valuation for the past 46 months!

DJIA MOnthly 1992 to 2007

The next graph shows the percentage difference between the DJIA and its 36-month MA. The over valuation that was produced during the bull market that ended in 2000, lead to a bear market, and eventual under valuation in 2003. This under valuation lead to the rally from 2003 to July 2007. 

DJIA Monthly 1992 to 2007

Since this indicator shows a state of persistent over valuation for the past 46 months, it confirms the previous three studies that are signaling that stocks are anything but cheap, they are very expensive!

Most of the commentators who are claiming that stocks are cheap have not considered this historical record, and they also have a very strong built-in bullish bias. These studies argue that stocks are NOT cheap, they are very expensive, which means that it is NOT a time to be buying stocks; it is a time to be selling!!

DISCLAIMER:
THIS CONTENT IS FOR EDUCATIONAL PURPOSES ONLY, and is NOT INTENDED AS INVESTMENT ADVICE!


The Information contained in this article reflects an analysis of market trends and conditions, and nothing contained in this article, or on this website should be interpreted as, or deemed to be, a recommendation to any investor, or category of investors to purchase, sell or hold any security.

Any investment decisions must in all cases be made by the reader, or by his or her investment adviser. Nothing contained on this website is intended as a solicitation for business of any kind, or for investment.

As a matter of law, INVESTMENT ADVICE may only emanate from members of the government-created monopoly of federally-registered brokers and investment advisers. The author falls into neither category.

In contrast, what you just read is simply INFORMATION, that was obtained from what are believed to be reliable sources. It is ALWAYS wise and prudent to undertake investment positions only after considering a wide variety of information and opinions, on the subject, and after consulting with those who are authorized to give INVESTMENT ADVICE, if so desired. Although consultation with "experts" may be helpful, everyone should do their own DUE DILIGENCE regarding ANYTHING that may affect their financial well being.

The author is an active participant in the markets, and may trade the securities that are discussed in this article, both before and after publication, and/or may have a long-term position in such securities. In other words, the author usually has a financial interest in the subject of the articles on this web site.


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