Stock Market: Valuations and Optimism Near Extreme Levels

Stock Market ValuationsTo gauge how overpriced a stock market is, I pay close attention to the valuations investors are giving to companies—how much they are willing to pay for every dollar a company makes.

Consider the recently debuted company Shake Shack Inc. (NYSE/SHAK). It has a price-to-earnings (P/E) multiple (i.e. how much investors are willing to give for every dollar of earnings) of 1,100. The industry this company belongs to has an average P/E multiple of just 42.

By this measure, Shake Shack is 25 times more expensive than its peers! And Shake Shack’s revenue figures are not impressive; the company barely makes a profit. Last time I saw the sort of valuations that Shake Shack is getting was in the midst of the Tech Bubble of 1999…and we know how that ended. (Source: Reuters, last accessed May 6, 2015.)

From a historical perspective, the stock market is overpriced. The CAPE multiple for the S&P 500 (that’s the P/E multiple adjusted for cycles), stands at 27.17. Comparing its current valuation to its historical average of 16.61, the S&P 500 is overpriced by 64%! Since 1881, the CAPE ratio for the S&P 500 has gone above 27.17 just five percent of the time.(Source: Yale University, last accessed May 6, 2015.)

Investor Optimism Soaring

Not only are investors paying top dollar for stocks, but they are way too optimistic on the stock market.

In the first quarter of this year, the Wells Fargo/Gallup Investor and Retirement Optimism Index reached the highest level since 2007! (Source: Wells Fargo & Company, March 5, 2015.)

The chart below depicts the American Association of Individual Investors’ bearish investors’ sentiment. The percentage of investors who hold a bearish opinion towards the stock market continues to decline in numbers to near record lows.

American Association of Individual Investors Chart

Chart Courtesy of StockCharts.com

Is the Top in for the Stock Market?

Dear reader, predicting exact market tops and bottoms is difficult. But looking at investor optimism and how much investors are willing to pay for stocks (valuations), we are certainly at a market top or close to it. If the Federal Reserve changes its mind and decides not to start raising interest rates this year, or if the Fed starts printing money again, stocks will move higher. But the chances of rates not going up in 2015 and the Fed starting to print money again this year are minimal.

Looking at the performance of the key stock indices so far this year, if you bought an index fund on the first trading day of 2015, you probably haven’t made money this year. Stock markets are up one day, down the next day. The year 2015 has had the worst start to trading out of the past five years. To me, I see the market putting in a huge top here; the hefty valuations of stock market indices are a disaster waiting to happen.