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Are Stocks Overpriced And Forming A Bubble?

Invented by the 2013 Nobel-prize-winning economist Robert Shiller, the Shiller PE is a widely-watched measure of the stock market’s health, and it recently turned negative, indicating the U.S. stock market is overpriced and ripe for a fall. Should you worry?

As the stock market was soaring to new highs just before the start of 2014, the Yale University professor’s key barometer of the stock market value rose above 50%, indicating that stocks were overpriced.  While disagreeing with a Nobel economic laureate’s opinion on investing is an unenviable position, the negative signal from the Shiller PE is a statistical aberration, an anomaly caused by the recency of the worst financial crisis in generations.

The Shiller PE uses a 10-year average monthly p-e ratio as the denominator in an equation measuring whether stocks are expensive.  This period includes the 2008-2009 financial crisis, a once-in-78-year economic and financial occurrence.  Including that once-in-a-lifetime event in a 10-year average PE calculation skews the numbers unrealistically toward the negative.

Stocks are actually trading at a reasonable level by most measures.  While some of the financial talk shows on TV have been saying stocks are in a “bubble” or even overpriced, much evidence exists to the contrary.

To see what a stock-price bubble looks like, look at the figure above.  It tracks the price of the Standard & Poor’s 500 index — a measure of America’s blue-chip companies — versus actual and projected corporate earnings on the 500 companies in the S&P 500 index.  The gap between the black line, which represents stock prices, and the green line, which represents earnings, depicts the growth of the tech-stock bubble from 1997 to 1999.  The correlation between the S&P 500 and stock prices broke down in the tech bubble. No such breakdown is occurring now.

Another key measure of whether stocks are overpriced is shown below.  The two green lines represent the historical trading range of stocks during a benign inflation environment like we have been in for the past few years.  The lower green line shows where stocks would have traded if investors had valued stocks at $15 for every dollar of profits on companies in the S&P 500 index, while the upper green line shows a multiple of 17 times earnings. You can see how the price of the S&P 500 shown in black became disconnected from corporate earnings.

What’s it mean for stocks in 2014?  The red lines at the end of the green lines show forecasted earnings for the last quarter of 2013 and 2014. Estimated 2013 and 2014 bottom-up S&P 500 earnings per share as of October 31, 2013 was $109.67 for 2013 and $122.06 for 2014.  Past performance can never be taken as a guarantee of future results. However, if the consensus earnings forecast is accurate and nothing unexpected happens to derail corporate earnings, stocks would be dragged higher based on how investors valued stocks in recent months.  As 2014 was about to begin, and with stocks trading at 15.9 times 2013 earnings, the price of the S&P 500 was well within its historical valuation norm and talk of a bubble seemed unwarranted.



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