The stock market recently surpassed two very meaningful price points. The Dow Jones surpassed 14,000 and the S&P 500 reached 1,500 for the first time since 2007. Many people are now starting to wonder whether we are “due for a correction” or are we at a market peak. As I write this article the market indeed has pulled back from these highs. But what, if any, influence should these index levels have to do with investing long term?
I think there are at least a few important questions to consider when this type of thinking creeps into our heads.
Why should an arbitrary index price really matter anyway?
Did anyone wake up the day after the S&P 500 broke 1,500 and say “Well, I am not going into work today”? If any of you are business owners did you decide to furlough employees after seeing the Dow closed over 14,000?
The answer is clearly no. Does the psychologically significant index level affect the current natural gas boom in the United States or change the mind blowing advances and future potential of 3D printing? Of course not. Everyone is susceptible to the emotional stress of new market highs, but when you actually take a minute to reflect on why they should matter it seems kind of silly. We have lost sight of the fact that the markets represent partial ownership in real, tangible companies across the globe. Businesses are not going to change how they operate based on the number of an index.
But what about valuation?
With a little thought exercise it is easy to see that index price alone should have absolutely zero bearing on investment returns, but the market could still be overvalued, right? Sure it is possible. Anything is possible. But the US and World Economy are actually on much better ground than in 2007 and 2008. The 2012 estimated earnings for the S&P 500 is around $102/share. That is an all-time high and well above the $82/share that existed the last time the market indexes reached these levels. In fact, the forward P/E estimate for the S&P 500 is just under 15x. The last time the indexes reached these levels the P/E ratio was around 21x. In other words, the market was priced 40% higher at the end of 2007 than it is today.
The P/E ratio is not always the greatest measure of value either. At some point in 2009 the current P/E ratio of the S&P 500 was over 100x! This was due to the horrible earnings being reported at the time. But in hindsight we know this was the market bottom and would have been the perfect time to purchase equities.
The current P/E ratio of around 15x is actually right in line with the historical average. The Earnings Yield, which is the inverse of the P/E ratio, is right at 7%. This can be interpreted as the earnings the S&P 500 provide for each share of the market you own. Similar to a pidend Yield which is the amount of dividends provided by each share of the market you own. The current Earnings Yield aligns perfectly with the long run real rate of return of the stock market (10% – 3% inflation = 7%). So holding everything else constant when the market is trading at historically average valuation levels we would expect to get the historical average real rate of return going forward.
The evidence suggests the fascination with the numbers 1,500 and 14,000 are largely overblown. It is certainly possible to see a market correction but in the context of your long term investment plan market corrections are nothing more than a buying opportunity. Attempting to time the “peak” of the market has unquestionably been proven hazardous to your health and your nest egg. Just ask anyone who had money with any of the numerous advisors, hedge funds, or mutual funds last year who held excess cash to avoid the presidential election, European troubles, or the “fiscal cliff”…