A Milestone for the S&P 500: Are Stocks Too Expensive?

Posting my analysis on Target (TGT) last week and looking over recent posts left me wondering if I have been too bearish on the stock market and valuations lately. Prices relative to earnings have jumped over the last year and many of the great dividend stocks I love are looking expensive.

Despite higher prices, the markets continue higher with the S&P 500 touching 2,000 for the first time ever. Can investors afford to wait for value in a market that just won’t stop? Should you hold back on investing or adding to your favorite companies until prices come down?

The Shiller price-to-earnings ratio, a measure of prices that takes 10-year average earnings, is at about 26 times earnings for companies in the S&P 500. At that level, stocks have been cheaper 68% of the time over the last 25 years. Over the past 25 years, returns over the following three years have been in the low single-digits (between 2.5% to 4.5%) when prices were this high.

Some of my favorite sectors are looking a little lofty as well. Fixed income investors have piled into dividend stocks as yields in bonds have fallen. This has driven prices up but has brought dividend yields down. The utilities sector has jumped 22% over the last year, well over the 9.5% average over the last five years, and the average P/E is now 17.0 against a five-year average of 14 times trailing earnings. Consumer staples have underperformed but are still up 9% over the last year and have averaged 16% over the last five. The average P/E for the group is now 19.1 against a five year average of 16.5 times earnings.

The yield on the Consumer Staples Select Sector SPDR (XLP) has come down to 2.57% against a five-year average of 2.7% and the yield on the Utilities Select Sector SPDR (XLU) has come down to 3.55% from an average of 3.9% over the last five-years.

The simple fact is that prices have come up significantly and investors are just not seeing the same dividend rewards as in the past.

Not all is rainclouds

Even against higher prices and lower dividend yields, there are still reasons to be optimistic. Many companies have taken advantage of historically low interest rates to issue debt and build piles of cash. That cash, setting near a record at $1.23 trillion, is being paid out to shareholders in record amounts. Members in the S&P 500 spent $241 billion to repurchase shares and pay dividends in the first quarter, setting a new record from $233 billion in the third quarter of 2007.

With sales growth still a little sluggish, the record amount of cash is also driving a strong environment for mergers and acquisitions. This helps to support the market as sentiment increases and investors look to the next acquisition target.

While the economy is not growing as fast as many expected, employment is steadily rising and there appears little to derail the recovery over the next year. The European Central Bank finally looks ready to boost its own monetary stimulus to promote growth and economic growth in Asia should help support earnings for multinational companies.

The downside and the rational investor

The problem with most investors, many of which only need returns between 6% to 8% annually to meet their goals, is that they fixate on beating the market every year. This leads to always being fully invested no matter how expensive stocks get and then losing half your portfolio value in the next crash.

While stocks may continue to go higher, I usually take a more conservative view compared to other investors. After a 195% return over the last five years, I have exceeded my return goals and then some. I prefer to hold a little more in cash or safer bonds when the market starts looking expensive rather than stay fully invested. I may miss out on a few percentage points of upside but I also sleep well at night when the market euphoria turns and stocks take a tumble.

Stocks do not look wildly expensive but they are certainly not the bargains we saw just a few years ago. Many of my favorite dividend-payers have been bid up as investors search for extra yield in an environment of super-low rates. While dividend stocks normally trade at price-earnings premiums relative to the rest of the market, the higher valuations have me a bit worried for the total return I can expect over the next few years.

For the extremely long-term investor, watching valuations becomes less important and a plan for regular contributions into investments will smooth your costs over many market cycles. I would never suggest you completely neglect stocks due to worries about valuations but there is one strategy I absolutely love using when the bull market is looking tired…enjoy your money! Take that extra vacation or spend a little more doing the things you love. Have fun with the money you’ve worked so hard to earn. When the market drops, and it always does eventually, you will have the opportunity to buy some great dividend names at rock-bottom prices.

My advice in all this, as it always has been, is to understand what kind of investor you are and what returns you need to meet your financial goals. If you like the thrill of higher risk and need returns in the double-digits, then you will probably want to keep investing even as prices go higher. On the other hand, if you are a more conservative investor then you may want to be more selective in your stock picks.

We will continue to highlight great companies with strong cash returns here on DividendLadder. I promise never to pull any punches when it comes to giving you the facts on stocks, even if it means a couple of angry letters. Investing is just as much about the journey as the financial destination.


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