Are stocks overpriced again?
I’ve written in the past about the price-to-earnings ratio and why it shouldn’t be your only measure of value. I’m about to not follow my own advice. Don’t kill me.
A few months ago, I wrote a story about how the market looked undervalued based on a very conservative use of the price-to-earnings ratio. Instead of dividing the market price by the current year estimated earnings or last year’s earnings, you divide it by the average of the market’s earnings for the last 10 years.
“Normalizing” the earnings in that way makes it so your P/E isn’t heavily influenced by earnings bubbles. Any “fake” growth or market cycles that might artificially inflate the earnings will be offset by earlier years of lower earnings. The P/E based on 10-year normalized earnings was made famous by Yale professor Robert Shiller in his book Irrational Exuberance, which accurately predicted the tech and real estate bubbles.
Back at the market low of 666, Shiller’s P/E stood at about 12, well below its historical average of 16. In other words, investors who bought at the low would earn about 8.3% per year (1 divided by 12) versus the 6.25% that they settled for in the past. Since then, the market has risen 30%. Would the same measurement say the market is a bargain now?
Right now, the S&P 500 stands at about 903. We don’t have the last few months of earnings data yet, but given that it’s a 10-year average, it shouldn’t make a huge difference. If we take 903 and divide it by our old earnings figure, we get a new P/E of 15.6. That is, investors by buying now would get a yield of 6.4% on their investment, right in line with the average. According to the chart we ran with my story a few months ago, investors who invested at P/Es in that range got 10-year annualized returns of about 5.7% on average.
In other words, based on Shiller’s P/E alone, it doesn’t look like the stock market is as much of a bargain as it was in March, though investors aren’t overpaying for stocks either. Shiller updates his P/E every month. You can find it in the Excel chart on this page.
I do these sorts of calculations frequently, but mostly as an academic exercise. Investors with a long time horizon would probably be better served by coming up with an appropriate asset allocation based on age, risk tolerance, savings and other factors and sticking to it, regardless of what the P/E says. This isn’t because Shiller’s P/E is wrong. It’s simply because tracking the P/E (and all the other measures of value) is hard and takes time. If you screw up even once, you could seriously harm your savings.
Back in the March story for Money, I wrote that someone wanting to take advantage of the low valuations might make a slight shift in their allocation—maybe you could put an extra 5% to 10% in the stock market while prices are low. I’d have to go back to my sources to see what they think, but it doesn’t look like the case for that kind of shift is as strong now.
— Joe Light
