How to Evaluate Stocks at Record Highs

The question of how to evaluate stocks in this current climate is a complicated one, and it may depend on what type of investor you are.

How to Evaluate Stocks: The Growth Investor’s View

Right now, U.S. stocks are at all-time highs, with the Dow Jones Industrial, the S&P 500 and the Nasdaq all touching new highs on Tuesday after a brief late-January dip. But record highs are nothing new: over time, the stock market has always moved in an upwards trajectory—with some potholes large and small along the way, of course. Since its inception in 1928, the S&P 500, for example, has returned an average of just under 10% a year. Given that average, stocks are supposed to be at all-time highs quite often.

Thus, a growth stock investor would point out that stocks have severely underperformed that historical average over the last few years. Since September 2007, just prior to the subprime mortgage debacle and subsequent market collapse, the S&P is up 45%, or roughly 5% a year—half its usual annual return. The performance has been even weaker since the turn of the century, with large cap stocks returning an average of just 3.2% per year.

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In other words, as our growth investing expert and market historian Mike Cintolo regularly points out, U.S. stocks have been underperforming their historical norms since the late 1990s. And that means we’re due for a long, sustained rally, with new all-time highs becoming almost a monthly occurrence.

That’s how a growth investor would assess the current state of the market. But how would a value investor evaluate the current market? That’s an entirely different story.

How to Evaluate Stocks: The Value Investor’s View

According to the Shiller price-to-earnings (P/E) ratio for the S&P 500, which measures how expensive large-cap stocks are relative to their underlying values on a cyclically adjusted basis, the current P/E is 28.5. Only three times has the Shiller ratio for large caps ever been higher: right before the 1929 market crash, during the dot-com bubble (and subsequent burst) in the late 1990s, and just prior to the 2008-09 recession.

Just look at the chart:

 

How to evaluate stocks at such high valuations? Depends on who you ask.

To value investors like our own Roy Ward, chief analyst of the Cabot Benjamin Graham Value Investor advisory, that’s a major red flag. To him, the market is extremely overvalued right now, especially after the furious rally since Donald Trump was elected President. Thus, the market is due for a pullback, at least in the short term.

So, which view is right—the optimistic growth investing stance that stocks are at the start of a long-term rally, or the skeptical value investing belief that stocks are grossly overvalued and destined for some sort of comeuppance? It’s possible that both are.

Short-Term Dip, Long-Term Growth?

Mike could be right that a new bull market is underway, with stocks advancing to great heights over the next few years. However, Roy could also be right—that before stocks embark on a multiyear rally, a little air will be let out of the balloon first if investors get spooked by the historically high valuations, the recent interest rate hike and more to follow, or the reality of a Trump presidency setting in now that he’s about to be sworn in.

Few bull markets come without interruption, so perhaps U.S. stocks will pump the brakes to allow corporate profits to catch up with share prices before putting their foot on the gas pedal again.

Regardless of what happens, this much is true: in determining how to evaluate stocks in the current market, neither the growth investor’s take nor the value investor’s take is necessarily wrong. In investing, there are plenty of ways to make money—it’s why we offer 12 different investment advisories, each catering to a specific type of investor.

If you agree with Mike’s theory that stocks are in the early stages of an extended bull market, valuations be damned, then you should subscribe to his Cabot Growth Investor advisory for all the best growth stocks to play the impending rally.

However, if you share Roy’s concerns about an overcooked market, and would prefer to invest in only the stocks that are still conservatively valued, you should subscribe to his Benjamin Graham Value Investor advisory by clicking here.

Chris Preston

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