DOW 20,000 - Time to Celebrate or Time to Worry?Submitted by David Vaughan Investments, LLC on February 8th, 2017
by Stephen K. Hinrichs, CFA
Director of Investment Research February 10, 2017
As I watched the Dow Jones Industrial Average cross the 20,000 barrier for the first time in January, I couldn’t help but think about how much the world is different now than when the Dow first crossed the 10,000 barrier in 1999. Back then, investment professionals and CNBC viewers would have noticed the Dow hitting that magical level as it happened. But many investors back then probably found out about the Dow’s triumph by watching the nightly news that evening or by opening a newspaper the next day.
Fast forward to Dow 20,000 this year and most of us would not have imagined back in 1999 how one would find out the news in today’s world. If you are like me, my smartphone (I didn’t even have a cell phone in 1999) had notifications from the likes of CNBC, CNN, and the Wall Street Journal popping up at the very moment the Dow hit 20,000. My Twitter feed (I didn’t even know how to Tweet a year ago) also began to blow up with stories about Dow 20,000 soon after it happened. By the time the nightly news or the next morning’s newspaper ran stories about Dow 20,000, this was old news. Information flow is definitely much faster paced in today’s world; who would have believed back then that the President of the United States would be tweeting his thoughts to millions of followers virtually every day?
Not surprising given the constant news flow, many investors are unsure of what to make of all of the stories they see stating the market has reached an all-time high. Should the Dow’s rise above 20,000 be celebrated as an all-clear signal that stocks will continue to move higher, or should it be a sign of worry that the market has become too expensive given the rebound in stock prices from the 2009 market lows?
To reflect on the question of how expensive the current market is, I think it makes sense to remember that the level of the stock market alone isn’t the determination of how cheap or expensive the market is. Rather, one also needs to take into account the level of corporate earnings that are supporting those stock prices. By doing so, one can use a measure such as the price to earnings ratio to get a quick read on how expensive the stock market currently is in relation to other historic points in time.
For example: if one were to look at just the 25-year price chart on the S&P 500 below, one could easily conclude the market appeared expensive at year end.
But, the following price to earnings ratio chart of the S&P 500 over the last 25 years shows a different story. Note while the stock market was setting all-time highs in terms of price in late 2016, the P/E ratio of the market was not. According to data from Factset, the S&P 500 ended 2016 with a P/E ratio of 18.6 times trailing earnings. This is well above the valuation of the market at the market lows of 2009, but also well below the extreme valuation the market reached when “celebrating” Dow 10,000 in 1999.
So, should we be worried about the market making all-time highs? The answer is we should be worried when the P/E ratio of the market is reaching all-time highs. Fortunately for investors today, corporate earnings have also rebounded nicely since 2009 and this has kept the valuation of the market from also reaching all-time highs. As the current P/E level of the market is just above historic averages, it appears the market is more fairly valued than overvalued.