I read a piece yesterday written by Business Insider CEO Henry Blodget. As the executive in charge of one of the fastest growing financial news outlets, I generally feel that Blodget has a pretty good sense of what’s going on.
That’s why the piece he wrote concerns me.
He presents a simple argument: two reasons why he thinks the market is overvalued. The first is price, the second is Fed policy. We’ve written elsewhere on the Fed policy concerns. Let’s take a closer look at Blodget’s concerns about the market’s valuation.
His price argument centers around the valuation of the stock market as a whole. The chart below shows a form of price-to-earnings ratio called the CAPE ratio, the Cyclically Adjusted P/E ratio. It is a metric commonly used to determine the value of a market as a whole relative to other points in history. This version of P/E ratio was created by legendary Yale professor Robert Shiller.
As illustrated in the chart below, the stock market has only seen higher valuations two other times: in 1929, just before the infamous market crash that led to the Great Depression, and the run-up to the dot-com bubble bursting in 2000. That makes this a scary chart.
To be fair, this CAPE chart looks more ominous than the traditional P/E ratio we use, which currently sits at around 19.8. Some experts believe that the CAPE is more accurate because it is adjusted for business cycles.
Even when looking at this drastically different picture it is difficult to suggest that the market is “cheap.” In fact, based on the historical average P/E for the S&P 500 of 15.5, the market appears to be overvalued. Still, the valuation seems much more reasonable when you look at the pure P/E instead of the CAPE ratio.
This is compelling. But I would not say that it is damning.
However, Blodget points out that a monumental shift in Fed policy is underway. The Fed is currently shifting from monetary easing to monetary tightening. Right now we’re stuck in the middle – the Fed’s bond-buying programs are ending but it has not yet begun raising key interest rates.
Certainly this paints a bleak picture for the coming years, a forecast echoed by fund management firm GMO as illustrated in the chart below.
Sure, these are just historical charts and forecasts. The market has before and will again behave irrationally in the face of historical trends.
But it would be silly to discount this perspective entirely. Rather, it should help you use caution in your investment decisions – just in case you don’t already.
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