One of the elements of modern punditry that continually surprises me is the insistence that stocks are grossly overvalued.

As I have written repeatedly, stocks are more or less fully valued. However, since we don’t know what next year’s earnings are going to be, stocks can get cheap or expensive pretty quickly. It depends on whether earnings slow or accelerate. Although we don’t know what is going to happen, investors must make a probability assessment as to the possibilities. (More on this later).

It is true that stock prices are somewhat elevated relative to next year’s earnings estimates, which are typically too high. We also know this: Prices are nowhere near the highs of the huge stock-market bubble of the late 1990s. As of this week 15 years ago, the price-earnings ratio of the Standard & Poor’s 500 index peaked at an all-time high of 35.97.

Contrast that with today. The current P/E ratio — the trailing four quarters — is about 17. A bit high compared with the long-term average P/E of about 15, but not bubblicious. This has led to a steady drumbeat of valuation concerns not only from analysts, but fund managers, pundits, even individual investors. The bulls remain circumspect, the bears emboldened. We have heard about Shiller CAPE (cyclically adjusted P/E) — now about 24 — endlessly. Never mind that it has been overvalued 85 percent of the time since 1990. Evidence of exuberance is modest at best.

The main problem we run into is that valuation isn’t a timing tool. Overvalued stocks can and do become even pricier; undervalued stocks can and do become cheaper.

That is before we get to the possibility that something — anything — could go right. Economic activity might pick up. Interest rates could normalize. Fears of deflation could abate. Corporate revenue might accelerate.

Stocks are somewhat pricey, but that condition has persisted far longer than most people seem to realize. Investors who avoid equities the moment they cross their median P/E ratio will miss opportunities for compounding gains.

The bottom line is that what will happen to equities is a function of an unknown, mainly next year’s earnings growth. Your equity exposure is a function of your future expectations of that metric. Those of you who are bearish are likely expressing the view that earnings will decelerate or fall. Bullish investors expect earnings to accelerate from record levels.

This is what accounts for your investment posture, whether you are aware of it or not.


Originally published here


Category: Investing, Valuation

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

11 Responses to “How Pricey Are Equities?”

  1. dctodd27 says:

    What’s wrong with admitting that stocks are overvalued and also admitting they can go higher from here? Nothing that I can see.

    As far as not seeing signs of exuberance, page C5 of my WSJ this morning lists the trailing P/E on the Russell 2000 at 102.19.

    • Liquidity Trader says:

      Here is the link: WSJ

      Note the trend:

      1 year ago: 34.63
      Currently: 102.19
      Next year: 19.75

      What are we to make of that?

      • dctodd27 says:

        I’m no mathemologist but I think it’s saying the analysts are expecting next year’s small cap earnings to be 5x what they were last year. #hope

        It also shines a light on the difference between actual reported earnings and “operating” earnings…

  2. boris says:

    a number of valuation models (used by bears) show overvaluation: shiller p/e, stock market cap /GDP,
    Tobin’s Q, Crestmont p/e, SP500 trend line, and any model which assumes profit margin reversion. A composite of these models has had ~80% historical accuracy in predicting 10-year returns. Maybe
    this time is different?

  3. High valuation is expected when the money supply is so big now. Question is:
    1. Does HFT being ‘outed’ expose the true lack of volume in the markets?
    2. biotech bubble popped
    3. social networking valuation dropping
    4. 3d printing valuation dropping
    5. Overall indexes might experience accelerated selling.

  4. seems that ~when more of the Vacation-Rental stock gets committed..

    the SPX could see ~1600 in a hurry..

    similar to: “…5. Overall indexes … experience accelerated selling…”

  5. MacroEconomist says:


    Why are the 2000′s even a comp? And why also is there some sort of broad consensus that stocks were the “most overvalued” in 2000. In case people forget, growth was pretty good back then. Pensions were funded. Dollar was strong, oil prices very low (until 2000), housing affordable,….

    ROEs were also significantly higher in the 1990′s then today, hence stocks were deserving of higher valuations. 2008 market had a lower valuation and market fell more. 2014 market has a valuation similar to 2008 and the macro fundamentals are much worse. That’s actually quite scary.

    We have had 5 years of cost cutting, gross margin increase, you name it. It’s hard for me to see ROEs go up from here. In fact, they are barely up from early 2011, but valuations are significantly higher due single handedly to the Fed’s distortion of risk free rates and commensurate valuation expansion.

    For stocks to go higher you need

    1) Lower borrowing costs
    2) Productivity miracle coupled with strong top line growth

    Absent this, we’re probably in a big trading range with downside bias until the next bear market.

  6. ch says:

    Stocks typically don’t break without bonds breaking first, since bondholders only care about whether they are going to get their cash or not.

    Bonds aren’t breaking, anywhere (take a look at the Greek bond deal from last week.) Not while the Fed has their back.

    Until something changes there, stock valuations don’t matter, b/c bond valuations don’t matter.

  7. BenGraham says:


    With all due respect, I think you are failing to notice your own logical fallacies in this post. Namely, the Straw Man and/or Move The Goal Post.
    “modern punditry that continually surprises me is the insistence that stocks are grossly overvalued.”
    “we don’t know what next year’s earnings are going to be”
    “investors must make a probability assessment as to the possibilities”

    With these statements, you ignore that “modern punditry” is NOT focused on the unknowable next year’s earnings. It is focused on metrics that have historically reliable predictive power. If one is supposed to make a “probability assessment”, why focus on next year’s P/E and not those metrics that are 80-90% reliable? Why use the 1-year P/E as a yard stick at all? Why use such an unreliable metric to justify that the current P/E isn’t absurd enough to compare to 2000′s?

    And if someone says stocks are wildly overvalued and the market goes up anyway, that does not make them wrong. You could have CORRECTLY said stocks were overvalued in 1997 only to see the market lower 5 years later. Likewise in 2006. Is anyone going to say stocks were not overvalued in 1997-2000 or 2006-2007?