Spiders's Bear's Den
by Paul Larson ([email protected])

This duel may actually be one of the hardest for this Fool to write. Why? Because I am as passionate as one can get about investing in stocks, and I absolutely love the "Spiders" as an easy and low-cost way for average investors to buy into the market. It's also standard knowledge among our Motley writers that historically the stock market's average appreciation has been around 12-13% annually. We all know here at the Fool that four out of every five years the market will end the year higher than it started. Furthermore, stocks generally outperform all other asset classes over the long term, bar none. Sounds all good and dandy, right?

But there is a problem.

The problem is that stocks have run up so dramatically over the past four years that the valuation of the market as a whole has far outpaced the growth of its main fuel -- corporate earnings. As I will show in a moment, there is empirical cause for concern that over the nearer term stocks may be more likely to be headed south instead of north.

First, let's talk about dividend yield. As of this writing, the S&P 500 as a group is only yielding 1.35%. This piece of data alone may not be that shocking to those new to the market, but the number is far below the historical norm. Just one short year ago, the S&P 500 was yielding 1.69%. More importantly, the historical average dividend yield for the group is roughly 4.3%. Any way you cut it, the dividend yield on the S&P is at an all-time low.

Of course, dividend yield may be more irrelevant in this day and age where investors prefer capital gains over current income. But there's still no denying this particular comparison that says the S&P 500 is trading at some rather lofty levels.

The more important valuation metric I will talk about has to do with earnings. Just a year ago, the S&P was trading at less than 23x earnings. Even more shocking may be the fact that the S&P's historical P/E multiple over the past 25 years has roughly been 15x earnings. And where are we trading at now? Would you believe that the S&P 500 is actually trading over 30x trailing earnings?

For some historical perspective, the S&P was trading at roughly 24x earnings before "Black Monday" back in 1987. As recently as 1994 the index traded as low as 15x trailing profits. This July marked the first time the index traded at over 30x trailing profits, and like the dividend yield, it marks the richest multiple ever seen before. We're in uncharted territory here, Fools.

Every Monday on page C-3 the Wall Street Journal publishes the market's average P/E multiple and dividend yield. Let me suggest that these are important numbers for those investing in Spiders to keep tabs on. Let me repeat, the S&P has historically yielded 4.3% and traded at 15x earnings. They are important points to keep in mind when paying "only" 30x earnings for your favorite blue chip.

Of course, the economy has been about as perfect as you can get over the past few years, and some of the premium assigned the market is certainly justified. The combination of healthy economic growth and low inflation is an ideal situation. Low interest rates and low commodity prices have helped the market, but there's no guarantee that these positive influences are going to continue into the future.

Higher interest rates could be just the trigger that sends stocks falling back closer to their historical valuations. The Fed has indicated that its bias over the next several months is towards raising interest rates, and the bond market tends to confirm this belief. The yield curve, a graph of interest rates for bonds of different lengths of maturity, is extremely flat. In other words, the difference between short-term rates and long-term rates is rather low. Should this curve actually "invert," where short-term notes yield more than long-term bonds, it is almost a sure sign that interest rates are headed higher. Click here for a current look at the yield curve.

Increasing interest rates are a double-edged sword that tends to slice stocks to bits. Higher rates not only increase the attractiveness of alternative, safer investments such as bonds, but they also decrease the discounted present value of future corporate profits. Any financier will tell you that higher interest rates do not bode well for stocks as a group.

I only name higher interest rates as one of any number of potential causes for the market to take a tumble. Other possible triggers include increased inflation, higher commodity prices, lower corporate profits due to the Asian situation, a conflagration in the Mideast, and a loss of stability in China or Japan. I'm sure I'm missing a few other things that could go awry, but with valuations at historically all-time high levels, it would not take much to pop this market's balloon.

I'm trying not to be sensational here and exclaiming to "SELL EVERYTHING NOW!" After all, there will always be individual stocks in the market that savvy investors can spot and profit from no matter what direction the market goes. But we're not talking about picking individual stocks here; we're talking about the S&P 500 as a group. The problem I have is that I'm just not sure if buying the market en masse, with its currently inflated valuations, is such a prudent thing to be doing at this time. History teaches us that stocks are the only place to be for the long term, but history also teaches us to be very careful about investing at these valuations.

Next: The Bull Responds