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In last week’s blog we talked about the market and how it has reacted since the pandemic started.  The initial dip was fast and severe as bear moves typically are because of the fear and uncertainty that comes with that move.  As discussed, the recovery has been almost as swift and has reached many new highs.  In that blog we also alluded to the fact that the initial issues that caused the drop had not really been resolved but yet these new highs have been reached.   

So, what does this all mean?  I think this is a good time to have a discussion about the fundamentals of stocks, more specifically, the valuations of stocks.  One of the most popular ways to value stocks is by looking at the P/E (Price to Earnings) of the stock.  The price to earnings ratio can be a good way to compare if one stock might be considered overvalued in comparison to another but there is also a way using P/E ratios to determine if the market is overvalued as a whole. 

There is a tool called the Shiller P/E ratio.  This gives us a visual representation of the current and historical valuations of the overall market.  Below is the current shot of the Shiller P/E. 

As you can see by looking at the graph that stock valuations at these all-time highs seem to be rather high but are not the highest, they have ever been.  However, there have only been two times since the 1880’s that valuations have been this high as a whole.  Some would say this only makes sense as the prices rise the P/E should rise but that thinking is flawed because this ratio is tied to earnings and not just the price of the stock or overall market and that’s why we are able to tell is things are considered more expensive relative to the history of those same things.

As you can see from this chart that the P/E ratio has room to go higher, however there is lots of room for a drop as well.  So, if we look at this and think about our questions from yesterday, specifically, is this a unique situation?  Is this new? And how does it all play out?

Let’s answer those questions to see if it can shed some light on the current situation in the markets and what is possible going forward.  First, as you can see from this chart this level is not unique as it has been here before and even higher.  Obviously, this is not new either for the same reasons that it is not a unique situation.  So, the real question is how does this all play out?  There are many answers that can play out in this scenario but the two things that really concerns us as traders are, does the markets continue higher or are we due for a pullback?  The quick answer is we don’t really know for sure but there are signs and clues from history that can help us figure out what is most likely.

That is where tomorrow’s excerpt will be headed.  We will take a stroll down memory lane and try to extract wisdom from the ages to see if it can help us now.

Coach “Old Money” Holmes

Chart of the Day

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