Should We Be Worried About Valuations?

The second scenario is more problematic and occurs when a bubble or overexuberance is present. This is simply a case of expectations (current stock prices) becoming detached from reality (actual earnings). To be clear, this is a bad thing. The technology bubble of 2000 and the mania in 1987 were good examples of P/E's becoming extreme due to investor enthusiasm.

Where Are We Now?

Naturally, the next question is if we are seeing a "bad" overvaluation condition. Or are we experiencing the kind of overvaluation that tends to occur when the economy starts to recover from recession?

I will contend that we're currently experiencing the latter condition. The economy was shut down to try and control the spread of the virus. A severe recession resulted. Then the economy opened back up and a recovery ensued. However, the virus remains a problem and continues to have a negative impact on some parts of the economy.

But with vaccines being put into the public's arms daily and more vaccines on the way, the stock market is looking ahead to better days. As such, the P in the P/E ratio is rising - rapidly. The result is record high valuations.

That's my story, and I'm sticking to it.

Is It a Good Time to Sell?

However, there are times when taking some risk off the table when valuations become extreme does indeed make sense. Below is a chart of the S&P 500 and the GAAP P/E ratio. The red circles represent when valuations became "expensive" in the past. The "P's" on the chart indicate when the P/E ratio peaked (something that can only be known with the benefit of hindsight).

(Click on image to enlarge)

* Source: Ned Davis Research

As you can see, selling when valuations first became extreme (the red "Expensive" line in the lower clip), worked out beautifully in 1987 and in early 2008. However, such a plan was a complete failure in 1991, 1996, 2015 and in 2018.

For example, if you had sold when the P/E first became expensive in 1991 (8/31/1991 - with the S&P sitting just below 400), you would have missed out on one of history's all-time great bull market runs as the S&P rose roughly 275% before peaking in the late summer of 2000.

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The opinions and forecasts expressed herein are those of Mr. David Moenning and may not actually come to pass. Mr. Moenning's opinions and viewpoints regarding the future of the markets should ...

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