Overview

When it comes to the market what’s expensive is proportionate to the cost of money. How hard is money to come by? When liquidity conditions are very tight, one would expect valuations to be lower than normal all things being equal. When liquidity conditions are very loose, one would expect the market to be looser too and buy stocks at higher valuations.

So to assess valuation, one has to take into account liquidity conditions. Next to sentiment, valuation is the least useful indicator. What’s expensive can get much more expensive and what’s cheap can get a lot cheaper.

Further, some terrible bear markets, like 2007-2008 were not preceded by extreme stock valuations. There were plenty of other indicators in alignment but valuations leading up to the housing bust were very average.

Still, paying attention to market valuations can give you an idea of the risk/reward to buying stocks and what the prospects of future returns may be.

To determine valuation, I look at the PE Yields published by the WSJ. I use these because the normal P/Es of these are very well known and just by glancing you can get a sense of “really expensive,” “normal,” or “really cheap” which is all I’m looking for. I consider a P/E on the S&P of 15 to be normal.

This requires some deeper analysis however because right now the S&P is very heavily skewed toward megacap tech stocks that are typically more expensive than the historic market averages. The bottom 100 stocks in the S&P right now are about average historically while the top 100 are very expensive. This doesn’t necessarily mean that the overall market is expensive. Right now the S&P trailing P/E is around 18 which historically is expensive whereas many stocks in the S&P are very normal by historical standards.

Valuation tends to be closely tied to sentiment.