As the stock market approaches 22,000 as measured by the DJIA, market conversations become market

warnings: "The stock market is too high, the market is overvalued, it's time for a pullback, prepare for

turbulence and their taking away the punch bowl." While the future is always uncertain, there are two

sides to every story. Let's take market valuation as an example. The basic metric used by Wall Street in

measuring the value of "the market" is the P/E ratio (the price of the market divided by the earnings of the

companies in the market.) With the market surging to record highs, it is obvious that this measure of the

market's value would be rising as well. However, using historical averages to judge the current market

valuation leaves out some important factors that investors should consider when making investment

decisions.

Two traditional factors that influence the P/E ratio are the levels of inflation and interest rates. Inflation

depresses P/E ratios because the present value of future earnings is lower the higher inflation goes. The

record high levels of inflation depressed P/E ratios during the OPEC induced inflation of the 1970s. As

inflation goes lower, P/E ratios should go higher because future earnings become more valuable. The

higher the expected growth rate in earnings, the higher the P/E ratio in a low inflation environment.

Interest rates can affect equity prices because high interest rates on bonds can offer a competitive

investment to stocks. In the late 1970s and early 1980s, investment quality bonds yielded more than 15%.

When compared to a long-term return on stocks in the 10% range, buying bonds was almost a "no-brainer."

When interest rates collapsed in the 2010s, stock prices rose because bonds became less of a

competitor.

Another important and unusual factor that can affect stock valuations has recently emerged in many

studies about stocks themselves. Credit Suisse, in a study entitled: "The Incredible Shrinking Universe of

Stocks" reported that there has been a substantial change in the number of common stocks outstanding.

For several reasons, there are fewer stocks to buy. At the same time, buyers of stocks appear to be

increasing given global growth and the dynamism of the U.S. stock market. This shrinkage in stocks can

lead to a shortage—a valuation factor that can't be quantified. Recently one piece of artwork sold for over

$110 million due to its scarcity value. Antique cars are another example. In this environment, asking

about the P/E ratio of the stock market could be like asking: "what is the P/E of gold?"

Even though the stock market is hitting record highs, both corporate revenues and earnings surprises on

the upside are providing support for a continued rally in stocks. However, unless we get a boom in the

issuance of new stock or a decline in stock investing, stock market valuations may no longer conform to traditional P/E ratio measures of that value.

Thomas E. Nugent

Victoria Capital Management, Inc.