Valuation Worries

The Dow Jones Industrial Average surged through a key resistance point on Friday, and the index is positioned to move a lot higher. Be prepared for a bear case based on its historic valuation. The market is trading above its historic price-to-earnings ratio (most-often mentioned valuation metric) on both trailing twelve months and forward basis.

The thing is that stocks and markets don’t reach magical valuation points and then peak or turn, although it has happened with the market more than once (see chart).

In 1987, the stock market suffered a crash with the S&P 500, tumbling to 321 to 247 in three months before turning higher. There wasn’t a crash during the 1992-1993 periods where forward P/E peaked momentarily.

Purists only use trailing P/E ratios, which has many of them worried.

The S&P 500 sports the highest trailing 12-month P/E ratio among major indices, but it’s a lot using earnings estimated over the next year. The picture presents problems from money managers and value investors. Utilities, for instance, are significantly more expensive (trailing or forward) than historic norms, yet money continues to seek them out during hiccups and pullbacks.

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The valuation dilemma is why money is flowing into blue chip names, particularly as major indices breakout and as anxiety increases. New highs versus new lows on the New York Stock Exchange have begun to widen.

However, at some point, the rebound will become more convincing and buying will fan out beyond blue chip names; until then, blue chip names should do very well.