Well, that settles it.
Heavy sarcasm aside, we do have the major stock indexes hitting record highs in a still-lousy economy. And thanks to that lousy economy and the Fed’s expansionary monetary policies in response to it, we have interest rates near record lows, which by itself does a lot to raise stock prices. (You can explain this either as borrowing costs to buy stock being cheaper than ever, as the returns on a major stock substitute [bonds] being at record lows, or as the low interest rates raising the intrinsic, or present discounted, value of future stock earnings. These explanations are not mutually exclusive.) But does that make the current stock market an out-of-control bubble? The Fed has cut interest rates many time over the decades without creating stock bubbles. Let’s take a closer look.
Since there is normally some inflation in the economy, a better way to look at stock prices is to adjust them for inflation. J.C. Parets has done this. His index was last updated for Sept 2013, at which time the real (inflation-adjusted) S&P 500 index was 1729.86 (these numbers seem to be in 2011 dollars). Parets emphasized that this amount was 20% below the real peak value of the S&P, from March 2000. But March 2000 was no ordinary peak but the height of the dot-com bubble. The market could still be grossly overvalued yet be 20% below that amount. And the market has continued to soar in the two months beyond Sept 2013; the S&P is up another 8%, so now it’s about 12% below its all-time bubblicious peak. Two lessons I draw: (1) stocks have been a lousy investment over the past 13.5 years, averaging about -1% per year in real terms, with a ton of volatility; (2) stocks could well be a bubble right now, but how large a bubble?
A still-better way to look at the stock market is the price-earnings (P/E) ratio. The measure here compares the current prices of the 500 stocks in the S&P index to their companies’ profits over the past 12 months. This chart is updated every trading day, but right now the P/E ratio is 19.87, compared with the historical averages of 14.5 (median) and 15.5 (mean). The all-time high was 123.8 in May 2009, and the all-time low was 5.3 during WWI. One could compare the current P/E of 19.87 to the historical averages and conclude that the market is about 28% overpriced (19.87 / 15.5 = 128%).
But we’re still not done. The appropriate P/E is not the same at all times. When interest rates on corporate bonds (the leading alternative to stocks) are very low and expected to stay that way for a long while, the P/E should be higher. Right now the interest rate on A-rated 20-year corporate bonds is 4.71%. An economist-approved way to compare stocks and bonds is to compare the P/E on stocks to 1/i, or 1 divided by the long-term interest rate. If investors were indifferent between bonds and stocks and cared only about their expected return, P/E and 1/i should be equal. (The 1/e ratio gives you the present-day value of a fixed-income investment that pays you $1 per year forever when the interest rate is i forever.) Right now, 1/i = 1/.0471 = 21.23, which would suggest that stocks are a bit under-priced relative to bonds. Except (if you can stand yet another about-face) there is no good reason why investors should be indifferent between bonds and stocks. Most people are risk-averse and would therefore prefer a guaranteed real return of, say 2% on bonds than an expected 2% return on stocks that could wildly fluctuate. So with normal, risk-averse investors, P/E should be somewhat less than 1/i. And with interest rates expected to rise someday, even if not any day soon, we should probably plug in a somewhat larger value of i than 4.71%. If we plug in 5% instead, then 1/i = 1/.05 = 20, just a tad higher than the current P/E of 19.87, which now looks too high. Not necessarily scary-bubble high, but overvalued just the same.
So when you think the market is a little overvalued but not necessarily a lot, should you dump your stocks? I guess that I just don’t know.