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.

Dividend Yield

The dividend yield is the indicated annual cash dividend (most recent quarterly dividend times four) divided by the current price. For market indicators such as the Dow Jones averages and Standard & Poor’s indexes, dividend yield is found in Investor’s Business Daily and Barron’s.

Higher dividend yields occur when dividend payments are high relative to the stock’s market price; in general, this indicates an undervalued market.

Lower dividend yields occur when dividend payments are low relative to the stock’s market price; in general, this indicates an overvalued market.

The difficulty, of course, is determining what constitutes “normal” and what constitutes an extreme value.

Figure 1.
S&P 500 Dividend
Yield and Index
Since 1960

Dividends are considered useful in stock analysis because they represent direct cash flows to investors, they can’t be manipulated by accounting techniques, and they tend to be more stable than earnings. Thus, for individual stocks, the dividend yield (which relates dividends to price) is viewed by some analysts as a more reliable indicator of value than the price-earnings ratio (which relates price to earnings).

The issue is more problematic when it comes to using historical dividend yields as a guide to valuing the overall market. Over time, dividend policies have evolved. Many companies, for instance, decreased their emphasis on dividends when their tax treatment was less favorable than capital gains, using earnings for stock repurchases or reinvestments in other businesses that would benefit shareholders with more favorable tax consequences. In addition, the market itself today is less dominated by companies with traditionally higher dividend payouts. As a result, dividend yields for the market as a whole have gradually decreased over time.

A graphical illustration of the historical dividend yields helps to highlight market extremes, as well as changes in those extremes, over time. Figure 1 displays the monthly dividend yield of the S&P 500 along with the S&P 500 index value (the red line) since 1960. [The S&P 500 is displayed using a semi-log scale in which equal distances represent equal percentage changes throughout the chart.]

The dividend yield appears to bump against invisible barriers, but the range changes. In the 1960s and early 1970s, dividend yields did not dip much below 3.0%, coinciding with market tops and pointing to overvaluations. Market bottoms roughly coincided with yields above 3.7%, but the market bottom yield marker steadily rose over that time period, matching general increases in interest rates. Through the 1970s and early 1980s, 6% seemed to mark the high range.

Since the early 1990s, however, the yield has trended down, reaching a low of 1.1 in 2000, and then trending up slowly up to its current 1.9% level. Compared to the long-term average (since 1960) of 3.2%, even the current level would represent a red flag of overvaluation. But that long-term average red flag has been waving since the early 1990s. Clearly, the historical norm needs to be tempered by your judgment concerning dividend policies going forward if you are going to use dividend yields to gauge current market levels.

Price-Earnings Ratios

The price-earnings ratio provides another insight into market levels. The price-earnings ratio is the current price of a stock or value of an index, divided by annual earnings. The price-earnings ratio for the Dow Jones industrials can be found in Investor’s Business Daily, and ratios for a range of market indicators can be found in Barron’s.

Figure 2.
S&P 500 P/E and Index Since 1960

In theory, the market is fairly valued when stock prices reflect reasonable expectations regarding future earnings growth. Higher price-earnings ratios occur when prices rise faster relative to earnings; in general, this indicates an overvalued market, when investors are willing to pay more for each dollar of earnings. Lower price-earnings ratios occur when prices do not keep pace relative to earnings; in general, this indicates an undervalued market, when investors are not willing to pay as much for each dollar of earnings.

The price-earnings ratio for the S&P 500 along with the index value is shown in Figure 2, and once again a range of extreme values is apparent. Price-earnings ratios of as low as 7 served as pretty clear indications of undervaluation during the 1970s and early 1980s. In general, price-earnings levels above 20 have served as red flags for overvalued markets. Certainly the red flags were ignored during the Internet bubble, as price-earnings ratios hit 35.2 just before market came crashing down in 2000–2001. The price-earnings ratio has averaged 16.9 since the 1960s, and recently the ratio has been bouncing between 16 and 17, right around the long-term average.

The Historical Framework

Table 1 provides another historical perspective of the S&P 500’s dividend yield and price-earnings ratio, showing the average, high and low by decade, as well as the averages and extremes during bull and bear markets.

Remember when viewing this table that “high” and “low” indicates opposite extremes for dividend yields and price-earnings ratios:

  • Overvalued markets are indicated by high price-earnings ratios and low dividend yields;
  • Undervalued markets are indicated by low price-earnings ratios and high dividend yields.

This historical perspective can help you put the current market into proper context. But markets are dynamic, made up of a changing mix of individual stocks in a constantly changing environment.

When greater risk and uncertainty in company and market prospects are perceived, price-earnings ratios shrink as investors are only willing to pay a smaller amount for a given level of earnings.

Similarly, when less risk and uncertainty is perceived, price-earnings ratios rise and investors are willing to pay a much larger amount for a given level of earnings. You can use history as a guide, but make sure you temper it with an evaluation of the current environment.

Table 1. Historical S&P 500 P/Es and Dividend Yields
Market Cap P/E
Date Dividend
High 23.8 Aug-61 3.9 Sep-66
Average 17.8 3.2
Low 13 Sep-66 2.8 Nov-61
High 20.1 Apr-71 5.9 Sep-74
Average 12.7 4.1
Low 7.2 Sep-74 2.7 Dec-72
High 22.7 Sep-87 6.4 Jun-82
Average 12.2 4.3
Low 6.9 Mar-80 2.7 Sep-87
High 35.4 Apr-99 4 Oct-90
Average 21.9 2.5
Low 13.4 Oct-90 1.2 Jun-99
High 29.3 Mar-00 1.9 Sep-02
Average 20.6 1.6
Low 15.7 Jul-06 1.1 Aug-00
Bull Markets
High 35.4 Apr-99 6.3 Jul-82
Average 17.1 3.1
Low 6.9 Mar-80 1.1 Mar-00
Bear Markets
High 29.2 Mar-02 6.4 Jun-82
Average 15.9 3.4
Low 7.2 Sep-74 1.1 Aug-00

   Valuing the Market: An Alternate Approach
Another approach to evaluating current market levels is to use a valuation formula. However, the success of the valuation depends upon using expectations that are accurate and well-founded.

The table below presents a formula for valuing the market using expected earnings. Multiplying expected earnings by the historical average price-earnings ratio provides you with an estimated “normal” market level. The table also provides valuations of the market using low and high price-earnings ratios, providing a measure of the extremes.

The first section uses the current trailing 12 months’ earnings of $87.45, taken from S&P’s Outlook (January 1, 2008, issue), for the earnings portion of the formula. Multiplying the trailing earnings by the average price-earnings ratio of 16.9 leads to a valuation of 1478, which is slightly above the current S&P 500 level of 1348.

Valuations should be based on reasonable expectations, so the second section uses expected earnings for the earnings portion of the formula. Based on S&P Outlook’s 2008 expected earnings of $101.09, the formula paints a somewhat different picture, with an S&P 500 valuation of 1708, considerably above the current market level, indicating that either the market is undervalued, or earnings expectations are being rapidly revised downward.

Putting a Value on the Market

    Equation: Earnings × P/E = Market Value

Using S&P 500’s latest 12 months’ earnings and:
   Average P/E $87.45 × 16.9 = 1478

Using 2008 projected earnings for S&P 500 and:
  Average P/E $101.09 × 16.9 = 1708

Current S&P 500 Index (as of 1/18/08) 1348