This time, I wanted to be more objective and not do that. So I figured why not look at the Dow Jones Industrial Average components? It's not a great index as it's price weighted (which is ridiculous), but it has been highly correlated to the S&P 500 index over long periods of time anyway.
So I just googled Dow P/E ratio and up popped this page from the Wall Street Journal:
I almost fell out of my chair. 14x P/E for the Dow 30?! No way. I suspected this had to do with the price-weighting of the Dow (again, how ridiculous and arbitrary!) so I punched in some numbers on the spreadsheet and sure enough, if you just add up the prices of the component stocks and divide by the sum of the EPS, you get a P/E ratio of around 14x.
But nobody is going to buy that as representative of a broad market index valuation.
So I calculated the simple average of the P/E ratios of each component stock. I used the last twelve months EPS of each component stock as listed in the recent Barron's.
Last Twelve Months, Current and Next Year P/E Ratios
Sure enough, if you calculate a simple average of each P/E ratio, it comes out to 18.5x; a bit on the high side and certainly not cheap.
Just out of curiousity, I typed in the current year analyst estimates for each component stock (from Yahoo Finance). We all know analyst estimates can be wildy inaccurate. But since we are already almost done with the current year, I figure the December 2013 year-end estimate can't be all that bad.
Using current year estimates, the P/E ratio of the Dow 30 (using a simple average) comes to 15.11x. That's totally reasonable and I would consider that 'fair' for sure. The Dow is not expensive at all. Sure, 3Q and 4Q can come in lower than recent estimates but since 1Q and 2Q is already in the can, it can't change this figure too much unless we have a disastrous 3Q and 4Q.
The last column on the spreadsheet is certainly questionable. It's the analyst estimate for December 2014 year earnings. Earnings estimates for a year that hasn't started yet can be off by a lot depending on how the year develops.
But that figure, for what it's worth, comes in at 13.74x earnings.
I just took a quick look at the inside of an index to see where the overvaluation might be. The macro charts seem to show expensive stocks and above trend earnings but for me the problem is that it just doesn't feel like it. Other than a few pockets of mania, I just don't get the sense that people are rushing into stocks. The economy too is slow growing so it doesn't feel like corporate earnings are above trend (I know they are, but it just doesn't feel like a corporate earnings bubble). I know interest rates are low so that boosts corporate profits as it lowers interest expense, but it feels more like corporations are suffering from low rates as they are flush with liquidity.
Yes, the Fed pump priming (and others around the world) and fiscal deficit is highly stimulative, so earnings probably are higher than they would otherwise be.
So it's a little strange to me. People seem to hate stocks (rushing into alternative assets), and yet valuations are a little bubbly.
Having done this exercise, I can see how the market can be considered fairly valued. If you look down the list at each component stock, each one seems to me more or less reasonable. Not cheap, but not expensive either, except for maybe Nike, Home Depot and Visa.
Is this a picture of mania in the stock market? To me not at all. Coca-Cola at 40-50x P/E was indicative of something, but I don't see that sort of thing in the above table.
Sure, maybe corporate earnings come down. But if it comes down from current year estimate levels, the market may not be as wildy overvalued as some charts seem to indicate.
I just throw this out there as a thought, not an answer.