As market turbulence reaches maddening levels, I wanted to show you this. It’s something you don’t usually see near a stock market low…

Based on price-earnings (PE) values, the S&P 500 Index is now trading at the loftiest level of its 95-year history. (Although the actual S&P 500 did not emerge until 1957, its 90-stock predecessor launched in 1926.) The S&P’s current PE of 31 tops its 2000 peak reading by a nose.

Stock market valuations appear even more stretched from the perspective of other common metrics like the price-to-sales ratio, price-to-EBITDA ratio, and the “Buffett Indicator.”

On average, these valuation gauges place the S&P 500’s current pricing about 50% higher than its 2000 peak.

The Buffett Indicator, for example, shows the S&P’s valuation to be hitting all-time record highs that are 56% above the previous record highs of the 1999–2000 dot.com bubble.

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According to this valuation gauge, which Warren Buffett has praised as “the single-best measure of where valuations stand at any given moment,” a stock market is relatively cheap whenever its total capitalization (i.e., the total market value of all stocks on the exchange) drops well below 100% of GDP. Conversely, a stock market is relatively expensive whenever its total capitalization climbs well above 100% of GDP.

At the stock market lows of 2008–2009, for example, the market cap of all U.S. stocks plummeted to less than 60% of national GDP. From that bear market extreme, the S&P 500 Index has rocketed nearly 700%.

But the U.S. stock market now finds itself at the opposite extreme. The Buffett Indicator shows that the U.S. market cap totals a whopping 229% of GDP, which is more than double the average level of the last 45 years.

This sky-high reading does not automatically mean that U.S. stocks are close to topping out. But it does mean that stocks are far away from anything resembling a major low.

Bear in mind that the above chart measures only stock market capitalization. It ignores the corporate debt load that has grown alongside stock market values. If we were to add the $11 trillion of corporate debt outstanding to the $47 trillion of stock market value, the titanic $58 trillion sum of that addition would total nearly three times the U.S. GDP.

Even the Federal Reserve has noticed that financial markets have become a bit “toppy.”

“Vulnerabilities associated with elevated risk appetite are rising,” Fed Governor Lael Brainard recently observed. “The combination of stretched valuations with very high levels of corporate indebtedness bear watching because of the potential to amplify the effects of a re-pricing event.”

A “re-pricing event” is Fed-speak for “market crash.”

How did we get here?

The answer is remarkably simple…

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Multiple expansion.

That term refers to the phenomenon of investors paying an ever-rising price for each dollar of underlying earnings.

During the last 10 years, for example, the S&P 500’s PE has roughly doubled — from about 15 to 31. Therefore, all else being equal, the index would be selling for about half its current level if it merely returned to its 2011 PE ratio of 16 times earnings. And at that level, the Buffett Indicator would register a less gaudy reading of 110% of GDP.

To be sure, corporate profits have been growing year by year since 2011, which partly explains the rising stock price trend. But multiple expansion can claim a much larger share of the credit.

As the chart below shows, profit growth accounted for 64% of the S&P 500’s 200% advance over the last 10 years. Multiple expansion accounted for the rest.

When stocks become as pricey as they are currently, good things rarely happen. At the start of 2000, for example, U.S. stock market capitalization reached a lofty 144% of GDP. Over the next 10 years, the S&P 500 produced a loss of 24%. Even after including dividends during that 10-year span, the S&P delivered a total return of minus 9%.

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In other words, the stock market spent an entire decade turning $1 into $0.91. That’s hard to imagine, but it happened.

That said, a pricey market is not necessarily an unprofitable one. At the end of 2017, the stock market’s capitalization hit a then-record 152% of GDP. And yet, the S&P 500 has soared 68% since then.

Nevertheless, you don’t usually see record-high valuation readings near a stock market low, just before a major new uptrend is about to get underway. Nor do you see investors trampling one another to chase after a hot stock, simply because its price is soaring. That’s called the fear of missing out — FOMO — and it is the pervasive mood of the moment.

This unique kind of “fear” is the one that causes rational individuals to pay irrational prices for high-flying stocks… or to pay any price whatsoever for a stock, as long as it’s a high-flying one.

When FOMO is the dominant investor sentiment, valuation rarely figures into the investment calculus. Momentum is everything. Momentum and a good story.

Two Big Questions

No one needs a keen eye for balance sheets or income statements. They simply need enough of an eye to see a rising stock price… and to check out the online chatter that may be powering that stock to ever-higher highs.

They must also have enough bravado to “buy high” and believe they can sell even higher later. Seasoned investors sometimes scorn this practice as the “greater fool strategy” because its success relies on a “greater fool” paying an even higher price than what the earlier investor paid.

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But “great fools” can profit handsomely during manic stock market phases. Gains arrive so effortlessly that investing seems as “easy” as boiling water. The easier it becomes, the more folks like to chat about the next “hot stock.”

Should we be running for the hills or cowering under our bedsheets? Probably not. But we should exercise some degree of caution… even while continuing to invest in new opportunities.

Over the next few days here, I’ll try to answer two big questions:

• How did we get here?
• How can we profit in the meantime?

Today’s stock market offers no lack of higher than average risk. That’s clear. But many great opportunities remain in select portions of the market.

On Thursday, we published the Fry’s Investment Report May monthly issue.

In it, I discuss one of those great opportunities — and make my latest related stock recommendation.

You can get that brand-new pick as a member of the Investment Report by clicking here.

Regards,

Eric Fry

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NOTE: On the date of publication, Eric Fry did not own either directly or indirectly any positions in the securities mentioned in this article.