Are Stocks Too Expensive? Who Cares?

Dec 19, 2013 | Updated Feb 18, 2014

The S&P 500 is up close to 25 percent so far year and the market P/E is close to 20. The Dow skyrocketed 292 points today alone. By historical standards, those numbers are high. Is the party over? Is it time to protect those gains and become defensive? Should you make your buy and sell decisions based on these indicators alone?

Of course nobody can predict the future. But if you ask me if the market is expensive, I believe the answers is "yes" and "no". And to be frank, the question misses the point anyway. I don't believe you should base your investment decisions based on how pricey the market is right now. I'll explain shortly. But before I get to that, let's consider how expensive this market really is.

The Price to Earnings ratio, or P/E, is a very popular number that many people track. If this number goes up it means investors are bidding up the price of stocks and they are willing to pay more for every dollar of earnings. In other words, as the P/E climbs, stocks become more expensive relative to their earnings.

Historically, the average P/E is 15 for the S&P 500. And as I said the ratio is close to 20 now. By that standard the market is ahead of itself. But P/E measures current price relative to the S&P's 12-month trailing reported earnings. If you compare the market's price to its future earnings, the P/E falls back to 15. That's right on the button.

And P/E doesn't really tell the whole stock market story. We don't invest in a vacuum but choose among the competing alternatives of stocks, bonds and cash. As one alternative becomes more attractive, money pours into that option and out of the other two. This process never stops.

So how attractive are the alternatives right now? Interest rates are very low - breaking news... right? The 10-year treasury currently yields 2.85 percent. That is the return for a risk-free investment. One reason why the market has done really well is because enough investors don't want to tie up their money for that paltry amount. They prefer to take their chances in the market and that is partially what is behind the rally.

Will rates remain low?

I already admitted that I can't predict the future. I wasn't kidding. But let's consider the facts. The Fed is doing all it call to keep the economy chugging along. In fact, they pumped $85 billion into the system every month by purchasing bonds for several years. They announced today that they will reduce these purchases to $75 billion but they are still going to keep rates low for a very long time. The consensus is that rates won't rise until 2015 or 2016.

Why does the government want to keep rates in the basement? They want to get business to unleash their stash of cash (currently over $1 trillion) and create more jobs. By many accounts, that action is working. The Fed is tapering the purchases precisely because the economy is strengthening on its own. Unemployment has fallen faster than expected and other economic indicators are looking good as well.

Putting It All Together

Rates are low now. They will likely continue for a while. On top of that, the private business sector is moving forward and corporate earnings are growing. The economy is strengthening and unemployment is declining. I don't know how you read that but in my book that makes a pretty strong case for equities.

Of course I could be wrong. In fact, I guarantee that I'll be wrong at least part of the time. Even if it does do well, the market won't shoot straight up. It never does. But making investment decisions based on where the P/E is or how high the market has climbed in any given period is simplistic and an error in my opinion.

Embrace an approach to investing the suits your appetite for risk and financial profile. Then stick with it. It doesn't have to be "buy and hold" of course. But whatever it is, don't let current events sidetrack you.

Are stocks highly priced? Maybe. Should you change your strategy as a result? No way.