Extreme Anxiety: Evaluating Current Market Levels

Keeping an eye on the market over the last year may have given you a bad case of emotional whiplash, with its apparent moves from one extreme to the other. It is easy to get swept up in the euphoria of a bull market as market levels rise, and then succumb to the deep pessimism of a bear market as the bottom apparently drops out of the market. However, markets rarely stay at historical extremes; eventually, they move back toward “normal” levels, although the speed of this adjustment is far from certain. The big question is: What is a “normal” level?

While you look at the level of the market directly, direct observation rarely provides much insight. Market levels—the peaks and the bottoms—aren’t apparent until well after the fact. A more useful and practical approach to determine “normal” is to examine relative fundamental values over time. Two of the most common measures are the market’s dividend yield and the market’s price-earnings ratio. Both measures relate a key financial indicator to price; as the price changes, the ratios change to reflect new valuation levels.

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