Two months ago, we noted the great disconnect between the stock market and the economy: Housing was rolling over, unemployment was barely improving, the government had shot its wad...and stocks were still powering higher.
So much so that, on a cyclically adjusted PE (the only PE that matters), stocks had become 30% overvalued.
So how are stock values looking now that the market is crashing again?
Better, but still expensive.
Measured using our favorite valuation technique, Professor Shiller's cyclically adjusted PE analysis, the S&P 500 now has a PE of 19X. That's down from 23X just a few weeks ago. But it's still considerably above the long-term average (1880-2010) of about 16X.
Check out the chart below, from Professor Shiller's web site. The blue line is the cyclically adjusted PE ratio (CAPE) for the last 130 years. (The cyclically adjusted PE mutes the impact of the business cycle by averaging 10 years worth of earnings. This reduces the misleadingly low PEs you get at peak profit margins, like the ones in 2007, and the misleadingly high ones at trough profit margins, such as the ones we had last year).
Note a few things:
Blue line = cyclically adjusted PE; Red line = interest rates
Image: Professor Robert Shiller, Yale University
Now, you can also unfortunately see from the chart that valuation doesn't tell you anything about what will happen next. As the blue line shows, just because stocks are overvalued today doesn't mean they won't just get more overvalued. And they can stay even more overvalued for a decade or more.
But what the apparent overvaluation does tell you--or, at least, has told you in the past--is that your future long-term returns will likely be below average. There's a strong correlation between starting valuations and ending returns (high valuations lead to low returns and low valuations lead to high returns). And today's valuations can now be described as "high." (Not extreme, but high.)
Today's PE also clearly shows that stocks aren't "cheap" and that today's crash is not necessarily a "buying opportunity." Fair value for stocks is about 900 on the S&P 500. So it certainly wouldn't be surprising to see stocks trade back to that level and possibly below it.
Yes, you can argue that "it's different this time." You can argue that, since stocks have traded at an average CAPE of more than 20X for the past two decades, we're in a new normal. And you might be right. But they don't call "it's different this time" the "four most expensive words in the English language" for nothing.
You can also argue that "interest rates are low, so P/Es should be high." That argument is in vogue right now, because there's been an inverse correlation between P/Es and interest rates for the last couple of decades.
But take a look at the RED line in Professor Shiller's chart. The red line is interest rates. As you can see, if you go back more than a couple of decades, there's not much correlation. (In fact, as the great UK economist Andrew Smithers has observed, there's none.)
To embed this post, copy the code below and paste into your website or blog.
• How Long Before Hulu Blocks Google TV?
• 11 Ways Google Just Slapped Apple
• Why Google TV Is Now The Most Important Thing In Television
• Here's What Google TV Looks Like
• What Google TV Means for Advertisers
Suddenly we're producing way too much natural gas.
Ouch... Retail investors are getting bullish just as institutions are going the other way.
Similarities between now and the Great Depression are getting unconfortable and if we double dip, we're probably going to trip dip.
Contrarians may have had a field day betting on the euro, but currency woes are far from over.
It's official, the Chinese have got the gold bug now.
* Copyright © 2010 Business Insider, Inc. All rights reserved. Registration on or use of this site constitutes acceptance of our Terms of Service and Privacy Policy. | Disclaimer
Redesign by Intersect, Inc. | Powered by MongoDB | Hosted by Datapipe | Analytics by Empirical Path
Read Full Article »