The bull market is still riding high on optimism. How long will it last?
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Since the surprise election of Donald TrumpDonald John TrumpBiden slams Trump over golf gif hitting Clinton Trump Jr. declines further Secret Service protection: report Report: Mueller warned Manafort to expect an indictment MORE in November, stock indices have been on a tear, rising approximately 10 percent. Most market pundits expected the market to drop if Trump won the presidency, citing the well-worn investment axiom that “the stock market hates uncertainty.” And, if there is one certainty regarding Trump, it is that he is unpredictable. In fact, he has stated his affinity to be unpredictable on a wide range of topics from the rights to carry guns to foreign policy.

Investors are enthusiastic, largely based on Trump’s promises to lower taxes, lessen regulations, and boost infrastructure spending. However, are investors simply optimistic, or are they, as former Federal Reserve Chairman Alan Greenspan once quipped, “irrationally exuberant”? After all, there was much anticipation for the Dow Jones Industrial Average to hit 20,000. That happened five days after Trump’s inauguration. Since then, the index has gained an additional 800 points.

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Many market prognosticators are predicting the imminent end of the bull market in stocks and cite historically high market valuation metrics. One of the most commonly cited metrics is the price-to-earnings (P/E) ratio of the market indices. A P/E ratio measures a stock or an index’s price relative to its per-share earnings on an annual basis. The higher the P/E ratio, the richer the market valuation.

 

Currently, the P/E ratio (when calculated on trailing 12-month earnings) on the Dow is in excess of 21, while a year ago it stood at 17. The current P/E ratio is historically high, given that the average P/E on the Dow has been about 15 since 1929. It plunged to around 6 during the Great Depression and reached a high of more 44 in 1999 at the peak of the dot-com boom.

By simply looking at P/E ratios in a historical context, one could conclude that the market is overvalued. However, valuations should not be considered in isolation but in relation to other factors. Currently, the yield on the 10-year Treasury note is around 2.4 percent. A P/E ratio of 21 on the Dow looks a lot more attractive given the low rates of return on Treasury securities. Simply put, if interest rates were higher, it would be difficult to justify P/E ratios north of 21. However, with yields on Treasury securities at historically low rates, investors can rationalize paying a higher multiple of earnings for blue chip stocks.

The current dividend yield on the Dow stands at 2.3 percent, nearly identical to the yield on the 10-year note. In most market circumstances, the dividend yield on the Dow would be substantially lower than the yield on the 10-year Treasury. On a cash basis, investors are getting approximately the same annual return on the Dow Jones Industrial Average as they are on a 10-year Treasury note. And, of course, on average stock prices go up over time, and 10 years from now we would expect the Dow to be at a higher level than it is today. When placed in that context, the market doesn’t seem overvalued.

If interest rates were to rise precipitously, that certainly would put pressure on stock valuations. Investors would likely rotate from stocks to bonds in the event of dramatically higher interest rates. Bonds would be viewed as better alternatives to stocks, likely leading to lower stock valuations.

The forward trajectory of the “E,” or earnings in the P/E ratio, plays a role as well. If tax and regulatory policy changes lead to higher earnings, any potential over-extension of the Dow’s P/E ratio that investors see currently could come back into line with historical averages. The bottom line is that investors with a long time horizon should not feel angst about committing funds to the stock market at current levels. I believe in the investment idiom that “time in the market is more important than timing the market.”

As for the near term direction of the markets, who knows? None other than Warren Buffett said, “We have long felt that the only value of stock forecasters is to make fortune-tellers look good. Even now, Charlie [Munger] and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children.”

Robert R. Johnson, PhD, CFA, CAIA, is president and chief executive officer of the American College of Financial Services. He is co-author of Strategic Value Investing, Invest with the Fed, and Investment Banking for Dummies.


The views expressed by contributors are their own and are not the views of The Hill.