If you are thinking we have seen this level on the S&P 500 index before, you areÂ absolutelyÂ correct. As you can see, the last 16 years or so has been a roller coaster ride, with three separate bull runs to around these levels, and the prior two have ended badly thanks to bubbles bursting (dot-coms in 2000-2001, housing in 2008-2009). Â So do you want the good news first or the bad news?
The bad news is pretty evident from the chart. We have reached a triple top and U.S. stocks have now risen 125% from their lows made in March 2009. That is a huge move in just the last four years. It warrants being cautious in the short term, as the market does feel overbought here.
The good news is actually pretty good though. At the March 2000 peak of the dot-com bubble, the S&P 500 reached 1,553 and the index components earned $56 in profits. P/E ratio: 28 (the highest ever recorded). Students of market history should have realized that stocks were dramatically overvalued. (Author’s note:Â As a college sophomore at the time, I was less than well-versed in market history, so it was the beginning of my history lesson, and a very good one at that).
At the 2007 peak of the housing bubble, the S&P 500 once again pierced the 1,500 level, topping out at 1,576. Earnings for the index hit $88, giving the market a P/E ratio of 18. That is still a high valuation, but rather than being unprecedented, the market was simply at the top end of its historical valuation range. Dangerous, yes, but not unheard of.
You can see where I am going with this. Today the S&P 500 sits at 1,502 and 2012 earnings are likely to come in around $100. That P/E ratio (15) is only slightly above the long-term median of 14. So the U.S. stock market is not materially overvalued as it was in both 2000 (by a large margin) and in 2007 (by a smaller margin). Now, that does not mean we cannot see stock prices fall meaningfully from these levels. After all, P/E ratios aren’t everything (despite the dot-com bubble being far more dramatic in terms of overvaluation, the market actually fell more after the 2007 peakÂ becauseÂ theÂ economicÂ shock was larger), but U.S. corporations are now earning enough in profits to justify the S&P 500 trading at 1,500, especially compared with the two prior peaks on this long-term chart.
My takeaway: it makes sense to be cautious, but not alarmed.