Over the course of the last few weeks, I have spoken to four different hedge fund managers.
All four of the managers I have spoken to in the last two weeks made note of valuations being critical in the year ahead. With the Dow moving above 18,000 for the first time in history and with the market in overbought territory by most measures, the managers emphasized that current valuations would be important in stock selection in 2015. One manager even said their model has the market overvalued by 10%.
After hearing the managers talk about valuations, the need to look at historical data became apparent. Looking at the Shiller P/E Ratio for the S&P 500, you can get a pretty good historical view of current valuations and whether they are too high or too low. The Shiller P/E Ratio looks at the current earnings for the stocks in the S&P and then it adjusts the past earnings for inflation by using the Consumer Price Index (CPI) as the gauge.
As of December 26, the Shiller P/E Ratio was at 27.45 and that is the highest reading since May 2007. The fact that we are seeing data that resembles the data we were seeing in 2007 is somewhat concerning, but when you look at where the ratio was in 1999, it isn’t as concerning.
The highest reading ever came in at 44.19 and that was in December 1999. You can see in the chart how the S&P tends to top out when the Shiller P/E Ratio gets too high and then the two move lower together. During the huge bull market in the late 1990s and early 2000, the Shiller P/E Ratio went above the 30 level for the only time in history. What is really scary is that if you exclude that period, the last time the ratio was as high as it is now was back in 1929.
No wonder the hedge fund managers are so concerned about the valuations. When you start comparing data to only two other periods in history and they are prior to the crash in 1929 and right before the bear market of 2000-2003, there is good reason to be concerned it would seem.
Granted, the ratio moved above the 27.50 level in January of 1997 and then the market kept moving higher for another three years, so there isn’t anything magical about the ratio that says you have to get out of stocks right now. Perhaps you watch the ratio and if it starts rolling lower before the S&P starts rolling over, perhaps that is the sign that you need to switch your posture from a bullish one to a bearish one. After all, there are two things that can make a P/E ratio go down—either the price falls as the earnings remain constant OR the price remains constant as the earnings rise.
There are a number of things that could cause the market to fall and bring down the Shiller P/E Ratio, but the most prevalent threat to the market right now are the foreign economic conditions. Russia is extremely concerned about their economy and the finance minister predicted economic contraction of 4% in 2015. Japan is already in a recession and China’s economy has slowed tremendously. The European Union has concerns about their economy as well. If the global economic situation doesn’t improve, I can see 2015 being a tough year for U.S. stocks.
