Are Stocks Overvalued or Not?

Chip Corley |

The indicator most often used to measure stock valuations is the price-to-earnings (P/E) ratio. Currently, Wall Street estimates earnings for the S&P 500 at $111.72 over the past 12 months. The index now trades near the 2,400 level. Taking the current price and dividing it by the forecasted earnings equates to a 21.1 P/E ratio. According to many, including the media, economic luminaries, and fear peddlers, today’s P/E ratio is well in excess of its 50 year average of 16.4, or 28% above its historical norm. So, is the market roughly 30 percent overvalued, or not?

Fake news, alternative facts, and sound bites are part of what appears like a grand illusion of what’s real and what’s not. So, as is often the case, there’s the actual truth or more to the story, such as context. Without context the intended message is misunderstood. As a stock market historian, context is foremost to me. When it comes to blanket statements, such as, “The stock market is going to crash,” or “Only put your money in gold,” I pause and take a closer look. This breather allows me to do some research and reflection. After taking the time to gather the facts, I can review them and make the best decision.

It is affirmed that on face value the stock market’s P/E ratio is rich by historical metrics. However, when measuring valuation in comparison to interest rates, as represented by the 10 Year Treasury, things look interesting. Over the past 50 years, 10 Year Treasury Yields averaged 6.2%. In 1981, 10 year rates were 13.9% and the S&P 500 P/E ratio was 8.1. In 2017, the P/E ratio is 21.1 and rates are 2.4%. P/E ratios are suppressed during periods of high interest rates (inflation); whenever interest rates are low, P/E ratios tend to elevate. During this period, when rates on the 10 Year Treasury averaged 3.6% or lower, P/E ratios averaged 18.1. If rates stay low, and Washington implements fiscal growth policies that increase economic activity, then stocks aren’t quite as expensive as they are being portrayed.

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