Is the Stock Market Over-Valued?

As a general rule to my own investing habits, I tend to feel a little concerned when the S&P has had such a good run as it's done for the past couple years.  The reason why I get a little concerned is that throughout history, there has been times of boom and bust, and in more recent history, you had the stock market booms of the 2000-2001 dotcom and 2006-2007 home booms followed by pretty huge busts.  Booms have been around ever since there were ideas to invest in, and generally occur when new forms of technology make themselves apparent.  In the case of the dotcom boom, nobody new how to value internet stocks, and with home values, the new technology associated with specialty cuts in mortgage-backed securities presented a financial product as being more secure than it actually was.  In any event, it often pays to do some of your own financial research and so, one of the best ways to see if the market is over-bought is to check out the P/E (price to earnings value) of the S&P 500.

The P/E ratio in its most simple description is the price of the stock divided by the earnings per share.  Basically, it tells you how many times more valuable the stock is than how much money the company is actually making.  There's no set rule on what an appropriate P/E ratio is for any stock, and that's why you'll see such swings from very low to extremely high.  The important thing to note with P/E research is to see if anything has dramatically changed or if new technology/investing techniques warrant the change. 

I quick glance of the link I submitted above, you can see the historical P/E ratio of the S&P 500.  Everything looks pretty good until you get to 2001 (alright makes sense...dotcom boom), and then HOLY CRAP look t 2009!  What the heck happened here?  Well, obviously it's the fallout from the housing boom.  I think the incredible decrease in earnings relative to the stock prices of these companies played more into this high P/E ratio that people pushing up prices too much.  Either way you feel about it, the market was definitely over-bought. 

The chart tells you that the mean P/E ratio of the S&P over the life of the market is about 15.49, and it is currently pegged at just a little over 17.  This would probably start indicating over-bought territory, however I would argue that you should probably look at the past 20 years as they are more relevant historical information.  I also removed those two huge spikes as those are obviously outliers.  What you get is a new P/E ratio of about 20 which would suggest we still have some room to go in the market place. 

But what should you do even if the S&P is over 20 on a P/E basis.  If you're investing in the long term, and have a well diversified portfolio over multiple asset classes, then any sort of short term market fluctuation shouldn't bother you too much.  That said, if you start seeing the P/E shoot over 20, it might be a good time to contribute more towards bond funds or other kinds of investments.  Just my humble opinion.

Wonderful Moment of the Day: Warm sweaters.