Do Stock Market Valuations Matter?

ETFguide

Every single day we are barraged with an array of conflicting data about the stock market.

"Stocks are expensive," says Guru A. In the same conversation, Guru B proclaims, "Stocks are cheap." With the S&P 500 (SPY - News) hitting all-time highs, do stock valuations matter?

Using reported price-to-earnings ratios (P/E) for the trailing twelve months is the standard method for comparing historical stock market valuations. Advocates of this technique correctly argue that forward earnings estimates should be ignored because they are based upon hopeful thinking, analysts' biases, and false assumptions rather than fact.

The current P/E ratio for the S&P 500 is around 17.81. That's much less compared to the S&P's frothy levels of 29.41 in March 2000. It's also slightly less compared to the S&P's 19.42 P/E ratio in September 2007. Is it any wonder why the "stocks are cheap" crowd feel so confident?

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For the rest of us, there is scant evidence future stock prices will make their next big move based upon historical valuations. There is no light bulb in the stock market's brain that suddenly triggers a rally because stocks are cheap. Likewise, that same light bulb in the stock market's brain that suddenly triggers a selloff because stocks are expensive doesn't exist.

History, for those of us who still bother with it, shows us the stock market doesn't necessarily need to be grossly overvalued before it can suffer a severe correction. Have we already forgotten what occurred in 2007?

By historical standards, the U.S. stock market (VTI - News) in the fall of 2007 was a bargain compared to the stock market of 2000. But that still didn't stop stocks from declining almost 50% over the next 18 months.

Interestingly, the selling fear that gripped the 2008-09 stock market created its own historical distortions. The disconnect between stock prices and trailing earnings got so out of whack, the S&P's (IVV - News) P/E ratio topped 123!

In retrospect, people that used historically cheap P/E ratios in 2007 as a reason to buy stocks were badly misguided. Will the future be any different for people who use the same rationale as their guide?

Stock market valuations (SCHB - News) do matter, but emotion and psychology (or what technicians call "market sentiment") plays key roles in moving stock prices. This will always be the case so long as the stock market has human participants.

It's also good reason for never exclusively using stock market valuations as a basis for investing or not investing. The better technique is to use valuations in conjunction with other key fundamental and technical indicators for a more complete view. 

The ETF Profit Strategy Newsletter uses technical, fundamental, and sentiment analysis along with market history and common sense to keep investors on the right side of the market. Since the beginning of the year, 74% of our weekly ETF picks have been winners. (through Q3 2013)

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