Is the Stock Market Over Valued?

Here is an interesting chart from JP Morgan that highlights the last 2 significant pullbacks in the market. Past performance is of course not a guarantee of future results but there are important aspects of this chart to keep in mind.

The market is trading around 16 times forward earnings. This number by itself does not signal a market due for a correction. In fact it is pretty much in line with historical P/E multiples. Increased earnings have pushed this market higher. An important thing to keep in mind is that companies can increase their earnings per share (the number used to come up with the P/E ratio) by repurchasing their own stock. If fewer shares exist on the market, then the earnings per share will be higher (Fractions!).

With interest rates at historic lows many companies have been financing share buybacks with debt. So does this mean that this P/E ratio is artificially low and there will be a correction? No one knows for sure!

Top analysts are split on wether this bull market has another few years in it or if a correction is looming within the next six months. Timing these dramatic swings is nearly impossible and can be very costly.

Having a diversified portfolio with strong companies can shield investors from major disruptions in the market. These inevitable sell offs are GREAT buying opportunities. The market as a whole was trading at 10 times earnings in 2009. If you had cash at any point in 09, 10 or 11 you did not have to look hard to find great deals on companies with solid fundamentals.

What should you do in this market? It is true that it is hard to find undervalued companies at the current levels. Nevertheless you can still find high quality companies. Investing in companies that pay a steady dividend is the best bet when the market is due for a corrections (wether it be months away or years away).

When a stock price goes down, the dividend yield goes up, assuming that a company continues to pay the same dividend (this is of the upmost importance when selecting dividend paying stocks).

I will discuss the benefits of dividend investing further in a later post. The point of this post is to establish that:

1. The market will always cycle through bear and bull markets
2. No one can predict when the market will fluctuate
3. Investing in strong companies that pay a dividend alleviate the pains of a crashing market
4. A long term investment stagey is the best way to ensure that wealth is created in the stock market