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How Over-Valued Are Stocks?

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The bull market entered a new phase last year when it broke solidly above S&P 2,100 and bounced off that level after the election. The subsequent 10%+ rally is justified by accelerating economic and earnings growth, with Q1 expected to hit a 9% EPS advance, the highest since Q4 of 2011.

But with the trailing P/E multiple hitting nearly 22 times -- S&P 2350 / $108 EPS for 2016 = 21.75 -- many investors are looking for the end of the bull market based on valuation alone.

Given this pricey picture, it's a very good time to take a step back and get a read on just how over-valued the market might be.

Historically Speaking

We all know about the great Nasdaq Tech Bubble of 1999. Just how far away from a fair value P/E of 15X were big cap stocks then?

While the Nasdaq P/E was much higher, at the end of 1999 the S&P 500 flashed a trailing 12-month P/E multiple of over 29X. It had peaked even higher near 31X in July of that year.

And for broader context, the last six bull market tops all saw the S&P 500 trailing P/E ratio hit an average peak of 30X earnings. I doubt we get that high again after the lessons learned in the two bear markets of the previous decade, but it's certainly still possible.

Bottom line: Historically speaking, we aren't even close to a bubbly valuation peak that would have me concerned about the end of the bull market. Especially with 2-3% GDP growth, attractive interest rates, and the return of nearly 10% earnings growth.

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The Life and Death of Bull Markets

Bull markets don't die of old age or go out with a whimper. They tend to go out with a bang of euphoria as everybody and their brother are buying stocks with irrational exuberance.

The death of bull markets is also strongly correlated with two other events: economic recessions and inverted yield curves. We have danger of neither right now.

Instead of euphoric mania, what we got for 18 months in 2015 and the first half of 2016 was the S&P index struggling sideways between 2100 and 1800 as both institutional and retail investors reduced their exposure to stocks, thinking the next bear market must be around the corner.

That's because we were in an earnings recession brought about largely by the bear market in oil and the energy sector. Throw some worries about Europe, China, and the bond bubble on top, and fund managers reduced their expectations for equities.

Heads Down, Picking Stocks

Now all of that is in the rearview mirror and the two biggest macro drivers that matter for stocks - the economy and Fed monetary policy - are still huge tailwinds. They have fostered the return to robust earnings growth that fund managers can believe in.

And a mature bull market still has a big mission left to accomplish in this environment before he rolls over and dies. In two words, it's called multiple expansion. This is classic late cycle bull behavior as money keeps pushing into stocks as the only game in town and bonds have lost their safety luster.

Bottom line: The trailing P/E will continue to drift above 20X and the forward P/E will make its way to 19X. Euphoria is a ways off. Think 18.5 X $135 forward 12-month EPS = S&P 2,500 some time this year, with healthy 5% gut checks to keep them honest.

Expanding Economy + No Mania = BTD

Now that we've put the market's current valuation in proper perspective, it's easy to see why the market levitated to new highs this year while nervous bears wring their hands about this or that worry.

The strategists who don't make a lot of headlines are still the ones "heads down, picking stocks" as I like to say. They don't care about the Fed or China or Brexit. They block out that noise as they look out 2 to 3 years and picture the full realization of their investment picks.

This cycle is certainly unique with massive QE and extraordinarily low interest rates for as far as the eye can see. But most money managers, who "have to buy" stocks anyway, are using the playbook of all the bull markets before.

And that playbook says when the economy is humming gently, the Fed is friendly, and multiples are expanding, you get back to being fully invested. And for us that means we keep deploying the strategy that has worked for 8+ years: "buy the dip" (BTD) in our favorite stocks and ETFs.

Bottom line: April will bring a bunch of noise from worriers about "selling in May." And I hope they do. Because it will be another great time to BTD.

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Good Investing,

Kevin Cook

Kevin, Senior Stock Strategist at Zacks, is a leading expert in technical analysis and what makes markets move. He provides commentary and recommendations for Zacks TAZR.