On Friday, the Dow Jones Industrial Average index closed
at a one-year high of 9,864.94 -- 51% above its March 9 low
-- and the broader S&P 500 index closed just shy of its
52-week high. This furious rise has sparked intense debate
between bulls and bears on whether current prices are
justified, and whether the rally can be sustained.
There's no substitute for valuation
Based on the cyclically adjusted price-to-earnings
ratios (calculated using average inflation-adjusted earnings
over the prior 10 years), the blue-chip Dow appears to be
marginally overvalued -- certainly less so than the S&P
500:
Index (Segment)
Index Level (Oct. 9, 2009)
 Cyclically Adjusted P/E
(CAPE)
CAPE Long-Term Historical Average
Overvaluation
Dow Jones Industrial
Average (Megacap)
9,864.94
19.1
17.7
8%
S&P 500 (Broad Market/ Large
Cap)
1,071.49
19.0
16.3
16%
Source: Author's calculations based
on data from Dow Jones and Robert Shiller.
However, while the CAPE is one of the very few
consistently predictive indicators of
long-term performance, it's unreliable when it comes to
short-term performance. (If you know an indicator that isn't,
I'm listening.) In that regard, there is no saying that this
rally can't continue until the end of the year, or even
beyond.
Risk remains to the downside
Nonetheless,
the riskfor broadly diversified equity investors (e.g.
SDPR S&P 500 ETF (NYSE: SPY)
shareholders) is higher in the short term, as well. Combine
greater overvaluation with a higher degree of uncertainty
concerning the third-quarter earnings of its components, and
the S&P 500 looks more "combustible." Take a look at the
big Dow Jones names (that are also part of the S&P 500)
reporting this week:
Company
Reporting Day (Week of 10/12)
Volatility of EPS Estimates*
Intel (Nasdaq: INTC)
Tuesday
5.1%
Johnson & Johnson (NYSE: JNJ) Continued... |