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Market Rebound Causes Stretched Valuations

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Dec. 4 2020, Updated 10:43 a.m. ET

Investors’ quest for income and rush into defensive sectors is one reason U.S. stocks are at their all-time highs, but the stretch for yield may be leading many to overpay and take on hidden risks.

A confluence of factors helped the U.S. market rebound more than 12% from their October low, pushing valuations to their highest level since 2009.

Market Realist – US markets experienced violent pull-backs and a volatility spike in October. Markets experienced four consecutive weeks of straight losses until October 17, 2014. Volatility (VXX), as measured by the VIX Index, breached the 25-level mark for the first time in two years on October 15, 2014.

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Markets have rebounded from October lows

Today, markets seem to have exorcised the ghosts of October and buried them deep! What a difference a month makes. A market rebound of more than 12% from the depths seen in October has left investor sentiment buoyant. The VIX Index (VXX) has receded and is currently hovering around 13, as you can see in the above graph. Both the Dow Jones Industrial Average (DIA) and the S&P 500 (IVV) are at record highs while the NASDAQ (QQQ) is at its 14-year high. All three indices have come off six straight weeks of consecutive gains. The market rebound has seen the S&P 500 reach all-time highs on multiple occasions in November.

The market rebound has led to pricey markets

The market rebound has stretched valuations of US equities. The graph above shows Robert Shiller’s cyclically adjusted price-to-earnings ratio (or CAPE). Robert Shiller, the developer of the CAPE, defined it as the price of a share divided by the ten-year moving average of its earnings. The ratio is a popular valuation metric.

The graph shows how the CAPE ratio for the S&P 500 is currently hovering around 26x, almost as high as it was before the US financial crisis of 2008 (XLF). The price-to-earnings ratio has increased from around 15.5x last month to 17.2x currently. Stretched valuations mean fewer and fewer bargains in today’s pricey markets.

Read on to the next part of this series to understand the reasons behind the US market rebound that has caused such rich valuations.

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