Is the Market Too Hot to Handle?

Arguments of equity valuations are a fruitless exercise. There is no light bulb in the stock market’s brain that suddenly triggers a rally because stocks are cheap. Likewise, that same light bulb in the stock market’s brain that suddenly triggers a selloff because stocks are expensive doesn’t exist.

History, for those of us who still bother with it, teaches us the stock market doesn’t necessarily need to be grossly overvalued before it can suffer a severe correction. Have we already forgotten what occurred in 2007?

The S&P 500’s P/E ratio was just 19.42 in October 2007 compared to a frothy 29.41 in March 2000. By historical standards, the U.S. stock market in the fall of 2007 was a bargain compared to the stock market of 2000! But that still didn’t stop stocks from declining almost 50% over the next 18 months. 

Interestingly, the selling fear that gripped the 2008-09 stock market created its own historical distortions. The disconnect between stock prices and trailing earnings got so out of whack, the S&P’s P/E ratio topped 123.

In retrospect, people that used historically cheap P/E ratios in 2007 as a reason to buy stocks were badly misguided. Will the future be any different for people who use the same rationale as their guide?

Ultimately, stock market valuations do matter, but emotion and psychology (or what technicians call “market sentiment”) play key roles in moving stock prices, too. This will always be the case, as long as the stock market has human participants.

It’s also good reminder to never use stock market valuations exclusively as a strict basis for investing or not investing. The better technique is to use valuations in conjunction with other key fundamental and technical indicators for a more complete view.

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Ron DeLegge is the Editor of ETFguide.com, founder of the ETF(k) Retirement Group at LinkedIn, and publisher of the ETF Advisor Pro newsletter.