There's no denying that the current bull market has caught many professionals and individuals by surprise. Many are pondering on the sideline as to when and if this bull market will ever end.
Our recent study of market return (Analysis of Long-Term Return from Equity Market) suggested that equity on average will provide a rate of return between 9% - 10%, but one should be caution of the year-to-year fluctuation. Also, one should make a distinction between the return from the market and return to individual investor. The ladder tend to be lower due to an error in market timing. The biggest contributor that will determine your rate of return is the price you pay for any investment (mutual fund, ETF, real estate, or individual stock). When we look at individual stock, there's a high correlation between them and the market. That is, if the market appears to be overvalued and faces downward pressure, it would be difficult for an individual stock to break such trend.
This lead us to our next topic which is the current market valuation. Where do we currently stand based on historical market valuation? The data we've chosen to present is the data provided by Robert Shiller of Yale University (found here). While his data set spans far beyond 1950, the inception of S&P 500, we will not be using them since we can't validate the accuracy of his conversion.
The two key elements of market valuation are price earning ratio (P/E) and dividend yield. Let use inspect the first element, the P/E ratio. The current market P/E is 19. While one may say that the market is expensive, we need historical data to prove such claim. Based on the data, the market will on average trade between P/E of 18 and 20 thus placing the current state at or near fair value. The table below indicate frequencies in months that the market trade in specific P/E range. At P/E of 20, the market is at 78th percentile which statistically imply that there is a 22% chance for the market to continue to advance beyond current level.
| P/E | Months | Cumulative % |
| 6 | 0 | 0% |
| 8 | 52 | 7% |
| 10 | 65 | 15% |
| 12 | 78 | 25% |
| 14 | 72 | 35% |
| 16 | 79 | 45% |
| 18 | 147 | 64% |
| 20 | 110 | 78% |
| 22 | 38 | 83% |
| 24 | 32 | 87% |
| 26 | 18 | 90% |
| 28 | 18 | 92% |
| 30 | 18 | 94% |
| 32 | 10 | 96% |
| 34 | 9 | 97% |
| 36 | 3 | 97% |
| 38 | 3 | 98% |
| More | 19 | 100% |
Now let us look at dividend yield and its implication. Current dividend yield is 1.9% which place the current valuation in the 80th percentile (dividend yield has inverse relationship on valuation, higher figure imply lower valuation and vice versa). As such, there is less than 20% chance of market advancing beyond the current level.
| Div Yield | Months | Cumulative % |
| 1.0% | 0 | 0.00% |
| 1.5% | 49 | 6.33% |
| 2.0% | 111 | 20.67% |
| 2.5% | 60 | 28.42% |
| 3.0% | 110 | 42.64% |
| 3.5% | 154 | 62.53% |
| 4.0% | 88 | 73.90% |
| 4.5% | 63 | 82.04% |
| 5.0% | 45 | 87.86% |
| 5.5% | 34 | 92.25% |
| 6.0% | 28 | 95.87% |
| 6.5% | 12 | 97.42% |
| 7.0% | 14 | 99.22% |
| >8% | 6 | 100.00% |
To sum it all up, the market appears to be trading at or slightly above its fair value. The market, however, does not simply trade up (or down) to the average then revert course in the opposite direction. The fact that we have reached a valuation level not seen since the peak of 2007 hardly mean that the market can’t simply continue higher. Our study simply suggests that the odd of that happening diminish with every single point increase in P/E ratio. If we have to speculate, we would be incline to say that S&P 500 would reach 25 P/E before starting to taper off. Even so, one need to understand the historical perspective and statistics of the market before putting their hard earn money to work at this level.