1 Risk Beneath the Surface of the Market's New High

1 Risk Beneath the Surface of the Market's New High

U.S. stocks recorded solid gains today, with the S&P 500 rising 1.25%, while the narrower, price-weighted Dow Jones Industrial Average was up 0.84%. That was enough for both indexes to set new all-time (nominal) highs. (I specify nominal, because once you account for inflation, both indexes remain below their Oct. 2007 highs.) Small-cap stocks performed even better, as the Russell 2000 Index notched up a 1.40% gain, setting a record high of its own.

Not surprisingly, then, the CBOE Volatility Index (VIX) , Wall Street's "fear index," fell 3.8%, to close below 13. (The VIX is calculated from S&P 500 option prices, and reflects investor expectations for stock market volatility over the coming 30 days.) By historical standards, current levels of volatility are very low -- as they have been for much of this year. Today's closing value for the VIX is well into the bottom fifth of the series, going back to the index's inception in Jan.1990 (it represents the 15th percentile, for you statistics geeks); the average VIX closing value over the full series is 20.3.

A contrarian goes hunting for evidence
Naturally, any contrarian (or value-driven) investor might find record market highs and low expectations for near-term volatility a bit unsettling; but, on the face of it, neither market fundamentals nor investor sentiment look out of kilter. The S&P 500 is valued at just 14.8 times the estimate for companies' next 12 months earnings per share (15.6 times if one considers "as reported" earnings instead of operating earnings), which doesn't look like an extravagant price tag. (Note: By "next 12 months," I'm actually referring to the trailing 12 months through June 2014.)

Furthermore, the latest AAII Investor Sentiment Survey, dated today, doesn't suggest the presence of lopsided bullishness, much less wild-eyed euphoria. In fact, at 35.6%, the percentage of investors who are bullish with respect to the market over a six-month time frame is lower than the 38.9% average over the life of the survey, which began in 1987.

The invisible valuation risk
But there are some warning signs: By my reckoning, earnings estimates for the second half of 2013 and 2014 will almost certainly need to be revised lower, which means that the price-to-earnings multiples that I cited above are understated (i.e., the market is more expensive that it looks on the basis of current earnings estimates.) The cyclically adjusted price-to-earnings multiple (CAPE), which uses an average of trailing 10 years' inflation-adjusted earnings, doesn't suffer from that bias. As of today's close, the S&P 500's CAPE is above 24 -- very high by historical standards.

With the stock market setting new highs on a regular basis, investors may be tempted to rush into the market for fear of missing out. Stock pickers should resist this temptation, ignore the valuation of the broad market, and focus instead on selecting high-quality companies trading at reasonable valuations (or, for the more intrepid, lower-quality issues trading at exceptional discounts to intrinsic value.)

If you'd like an example of the kind of gem this risk-averse approach can unearth, you ought to read our special free report: "The Motley Fool's Top Stock for 2013." Just click here to access the report and find out the name of this under-the-radar company.

The article 1 Risk Beneath the Surface of the Market's New High originally appeared on Fool.com.

Fool contributor Alex Dumortier, CFA has no position in any stocks mentioned; you can follow him on LinkedIn. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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