The white line is the index's market value, while the green bars are the P/E ratios for the S&P 500. As shown, the market's anticipation of the markets and P/E ratios differ significantly.
For example, look back at the dot-com bubble period between 1996 and 2000. The S&P 500 was on a remarkable run, followed by a significant correction, as many of the stocks were way overvalued, trading above a 30 P/E ratio.
The market is always forward-looking, while fundamentals generally lag. However, strong trends in a company's stock price could be a fallacy if something drastic changes in the company's fundamentals.
Again, take a look at the Nasdaq 100 below. The index rose above 5,000 in the early 2000s, more than doubling in such a short period of time.
That was fueled by overvaluation in the technology sector because many market participants thought that tech stocks were the next big thing. As shown below, the fundamentals weren't really matching up with the market price.
There were consecutive quarters when the P/E ratios were falling and the Nasdaq 100 was rising. Keep in mind that it took the Nasdaq 100 multiple years amid low interest rates to rise back above 5,000 since the financial crisis.
That being said, it doesn't mean that we shouldn't follow fundamentals. Rather, we should be conscientious when using them to value a stock.
Instead of buying when P/E ratios are low, investors and traders were buying near the top during the dot-com bubble, causing many to lose out on their investments because they didn't do their proper due diligence or take profits.
Examining the two charts above seems to indicate that the markets might be in bubble territory this year.
"We're in a bubble right now, and the only thing that looks good is the stock market, but if you raise interest rates even a little bit, that's going to come crashing down. We are in a big, fat, ugly bubble, and we better be awfully careful," President-elect Donald Trump said.
"And we have a [Federal Reserve] that's doing political things. This Janet Yellen of the Fed," Trump said.
"And believe me, the day [President Barack] Obama goes off and he leaves and goes out to the golf course for the rest of his life to play golf, when they raise interest rates, you're going to see some very bad things happen, because the Fed is not doing their job. The Fed is being more political than Secretary [Hillary] Clinton," Trump said.
Now, what is most interesting about this statement? Trump is pretty much calling for a market crash when rates rise.
The ironic thing about his statement is that the markets have been climbing higher since was elected. The S&P 500 has been up nearly 5% since Trump won the election, and there could be a correction after he assumes office on Friday.
Let's take a look at Yahoo! (YHOO) , which was a highly valued company during the dot-com era.
When looking at Yahoo!'s price and P/E ratio in the chart above, the fundamentals didn't really reflect the stock price. Yahoo! was trading at nearly 3,500 times its P/E ratio at one point, which may have been unjustified.
Following that, the markets were quick to realize that the company wasn't that valuable, and it began to tank once the bubble popped.
Take a look at how Yahoo!'s market capitalization evolved over time. Prior to the dot-com bubble, Yahoo! had a market cap of less than $1 billion.
However, during the bubble, Yahoo!'s market cap rose to more than $100 billion at its peak. Thereafter, its market cap and share price fell significantly, with the former falling to between $5 billion and $10 billion.
That is more than an 80% drop in market value. It is cliche to say, but investors should practice buying when valuations are low and selling when valuations are high.