Are Stock Values High or Low?

It is a rare time when analysts aren’t debating whether stock valuations are high, low, or somewhere in between. The debate matters, because stock indexes peak when valuations are high and bottom when valuations are low. But valuation isn’t like an on/off switch. Stocks can be highly valued or low valued for a long time before the indexes make a strong move. That’s why you need to consider other factors. Valuations are a strong indicator only at extremes.

That’s why this piece is so interesting. (Subscription might be required.) It points to a different indicator than those among common use. It looks at the valuation of the median stock. Most valuations methods look at the valuation of an index or the entire market and use a capitalization-weighted method. Using the median stock valuation gives you an idea of how stocks in general are valued. The recent reading says that the media valuation is at an extreme level.

Thus he admits to having been somewhat discomfited when he recently chanced upon figures compiled by finance professor Kenneth French of Dartmouth’s Tuck School of Business. The numbers, from the CRSP database at the University of Chicago, detail stock prices and returns on all listed stocks going back to 1926. Nobel Prize–winner French found, for example, that according to midyear annual data, the median U.S. stock price in 2014 stood at a post-World War II high of over 20 times earnings.

The median price-to-cash-flow ratio, at 15, was also at a postwar high. In fact, the median P/E alone had jumped from around 12 at the depth of the Great Recession in 2009 to the aforementioned 20-plus.

To be sure, market-capitalization weighted indexes like the S&P 500 have sold at even more outlandish P/E ratios—more than 30 times during the 2000 dot-com mania. But high median valuations covering literally thousands of listed stocks, equally weighted, can likewise lead to trouble. “It’s the very stealth nature of the overvaluation without the obvious, headline-grabbing signs of overexuberance” that Paulsen says concerns him.

He points out that after previous highs of the median P/E in 1962 and 1969—periods most comparable to today’s broad-based high valuations—nasty selloffs of 27% and 35%, respectively, occurred.