How Today's Stock Market Valuations Compare to 2000 – and What to Do About It

Opinions on stock market valuations flow easily around Wall Street, too often without backing.

Looking at the typical measurement used to determine stock valuations, I'm increasingly cautious.

Indeed, some of the numbers are downright scary just now, both in nominal value and in terms of red-light factors blinking on the horizon.

When you put it all together, here are some of my concerns about our hard-earned gains, and what we can do to profit...

Market Conditions Today Echo 1999-2000

Overvaluation measures are emitting early warning signs that we can heed now.

The S&P 500 is trading at 18.5x forward earnings, above the historical average of about 16.5x. The Shiller cyclically adjusted P/E ratio is currently about 26x the historical average of 16x. One popular measure used by bulls to justify current valuations and to deny that stocks are overvalued is to compare today's prices to those at the market peak in 1999-2000 during the Internet bubble.

Recently, MarketWatch columnist Brett Arends published a report suggesting that today's market is actually just as expensive as it was in 1999-2000. The dot-com era was notable for ridiculous valuations for companies that had no revenues or earnings.

Still,the overvaluations hit a limited number of large-cap growth stocks that rose with the tide especially hard, such as Microsoft Corp. (Nasdaq: MSFT), Cisco Systems, Inc. (Nasdaq: CSCO), Intel Corp. (Nasdaq: INTC). The rest of the market was not as overvalued. The median valuation for the top 1500 stocks by market cap today is actually higher than it was in 1999-2000, according to Mr. Arends:

Median P/E today is 20x compared to 16x in January 2000. Median Price/Book today is 2.5x compared to 2.2x in January 2000. Median Price/Revenue today is 1.8s versus 1.4x in January 2000.

There are aspects of the markets that point to better valuations today. Dividend yields are higher today (1.3%) than in January 2000 (0.8%), partly due to the lower tax rate on dividends that now exist. And the earnings yield of the S&P 500 is 6.8% today versus 2.5% back then. But earnings today remain at record levels as a share of GDP, and these have normally mean-reverted. With earnings flattered by record low interest rates, low effective tax rates, and high levels of stock buybacks (which are occurring, in case nobody noticed, at pretty high stock prices), the likelihood of conditions continuing to support high stock prices should, at the very least, be questioned.

Understand the Risks, and Profit

The real question is whether high stock valuations are justified today in view of the significant risks that are staring stocks in the face.

The most significant risk is the end of the Federal Reserve's unprecedented easy money policies. The Fed has continued to employ crisis-era policies well beyond the end of any crisis. The result is that stock market investors have benefitted from zero interest rates long after the rationale for such low rates has vaporized. While the Fed is clinging to reasons such as a sluggish labor market and low inflation to justify the extension of low rates long past the time when they are justified, recent employment and inflation data indicate the time has come to raise rates.

The second most significant risk is the geopolitical havoc occurring around the world. Ukraine attacked Russian troops moving into its territory, sending stock prices around the world plunging (and bond prices rallying even further, sending bond yields to new lows for the year as investors sought the safety of Treasuries and German bunds). ISIS continues to carve its way through Syria and Iraq, threatening the uneasy balance of power in the Middle East and threatening vital Western interests and oil supplies. Geopolitical stability is decidedly bad for stocks, particularly stocks that are trading at very high valuations.

The third most significant risk to stocks is that corporate earnings will not keep pace. Recent retail data was very disappointing. Wal-Mart Stores, Inc. (NYSE: WMT) reported decreased earnings and told a story of higher healthcare costs and reluctant consumers. Worried consumers are also causing problems in other non-retail areas. Regional gaming is a high-profile example, with the collapse of four casinos in Atlantic City resulting in the loss of an estimated 8,000 jobs.

Corporations may have squeezed about all of the cost savings they can out of their businesses. While companies continue to "beat" expectations, the truth is that they are more leveraged than they were in 2007 on the cusp of the financial crisis, and they live in fear that interest rates are going to rise and they will not be able to service their debt.

The lesson for investors is simple. An expensive market is always vulnerable to bad news and sell-offs. Today, the bad news is not a sudden "Black Swan," but more obvious risks out there for all to see: The risk of a geopolitical blow-up is extremely high, the Fed is about to end QE and is likely to raise rates by the end of the first quarter of 2015, and corporate earnings are under pressure.

Investors should take heed of these realities and move defensively before they start giving back the hard-won gains of the last five years. Trailing stops and informed stock shorts are just some of the ways that investors can retain, or create, gains when anticipating a downturn.

Editor's Note: Special Contributor Michael Lewitt publishes the highly regarded The Credit Strategist, and was recognized by the Financial Times for forecasting both the financial crisis of 2008, and also the credit crisis of 2001-2002. His 2010 book, The Death of Capital: How Creative Policy Can Restore Stability (John Wiley & Sons) was included in the curriculum at the University of Michigan and Brandeis University.