Despite a period of volatility in March, it’s turning out to be another banner year on Wall Street. In recent weeks, the iconic Dow Jones Industrial Average (DJINDICES: ^DJI), broad-based S&P 500 (SNPINDEX: ^GSPC), and technology stock-propelled Nasdaq Composite (NASDAQINDEX: ^IXIC) all rocketed to record highs.
There’s a lot piquing investors’ interests at the moment, including:
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The evolution of artificial intelligence (AI)
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The advent and proliferation of quantum computers
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The imminent initial public offering of SpaceX
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Better-than-expected corporate earnings
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Record S&P 500 share repurchases
But as history shows, the stock market doesn’t move higher in a straight line. While the Dow, S&P 500, and Nasdaq Composite absolutely have increased in value over the long term, Wall Street can take investors on some wild rides over shorter timelines.
Based on one virtually unprecedented event that we’re witnessing right now, we appear to be on the verge of a big move in stocks.
Stock valuations are otherworldly
While there are several reasons to question the sustainability of Wall Street’s bull market rally, including record margin debt, a historically divided Federal Reserve, and the ongoing effects of Trumpflation, it’s the stock market’s otherworldly valuation that should give investors pause — especially in light of history.
To state the obvious, valuing individual stocks or the broader market isn’t black-and-white. Since value is entirely subjective, what one investor considers pricey may be a bargain to another. The subjectivity of evaluating and valuing stocks is one of the main reasons short-term moves in the Dow, S&P 500, and Nasdaq Composite are so challenging to predict with any sustained accuracy.
But there is a time-tested valuation measure that does an exceptional job of cutting through investors’ emotions and subjectivity to provide an apples-to-apples comparison of broad-market valuations: the Shiller Price-to-Earnings (P/E) Ratio, also known as the Cyclically Adjusted P/E Ratio (CAPE Ratio).
When most investors “value” a stock or the broader market, they use the traditional P/E ratio, which is based on trailing 12-month earnings per share (EPS). The problem with the P/E ratio is that it loses its usefulness during recessions when EPS can turn negative.
