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Dow Jones Industrial Average (.DJI), S&P 500 (.INX): Are Stocks Too High?

Both of the major stock market indexes have not only recovered from the financial crisis. They have proceeded to new heights.

Although the Dow Jones Industrial Average (INDEXDJX:.DJI) is down from its recent all-time peak, it continues to trade over the 15,000-point threshold. Meanwhile, the S&P 500 (INDEXSP:.INX) has, at least for the moment, settled above 1,600 points.

Dow Jones Industrial Average 2 Minute (INDEXDJX:.DJI)But far from being something to celebrate, it forces us to ask: Are stocks too high?

To appreciate why this is a concern, one need only glance at the preceding figure, which charts the daily closing price of the S&P 500 going back to 1950. There’s a disturbing trend developing that consists of wild booms and busts.

First there was the dot-com bubble. Then the housing debacle. And now, at least insofar as the chart seems to suggest, we’ve found ourselves in yet another nearly identical situation.

The support for this proposition is twofold. In the first case, and particularly since last September, the Federal Reserve has pumped $85 billion a month into the bond markets. Doing so has driven bond prices higher and therefore, at least presumably, increased the flow of funds into equities. Once this spigot is turned off, it’s widely assumed that stock prices will respond in kind.

And in the second case, there’s no getting around the fact that valuations are higher than the long-run average. As of Friday, the S&P 500 was trading at 17.83 times earnings. And if you take the past 10 years into consideration, it’s an even dearer 23.77 times earnings as of the middle of this month. By comparison, the average multiple since the 1880s is only 16.49 times earnings.

The one thing that can be said in favor of current equity prices, on the other hand, is that corporate earnings are increasing. As the following chart shows, corporate profits have climbed to around 11% of gross domestic product, far and away the highest level ever.

So how should you reconcile these points? I think the proper conclusion is that stocks are indeed priced too dearly. But whether you should respond is another question altogether. If you’ve established a consistent pattern of investing irrespective of cycles, then this shouldn’t throw you off kilter.

If you have yet to do so, however, and are just now considering it, then you’d be wise to think twice before taking the plunge at today’s valuations.

The article Are Stocks Too High? originally appeared on Fool.com.

John Maxfield and The Motley Fool have no position in any of the stocks mentioned. 

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