Investing expert Robert Johnson explains why the PE Ratio alone shouldn’t be used to determine whether or not the stock market is overvalued.
Peruse any financial website, watch CNBC, or listen to Bloomberg radio and invariably you will find financial experts commenting on the supposed overvaluation of the stock market. It seems that more people are anxiously anticipating the end of one of the longest bull markets in history than are enjoying and participating in the continuation of the market advance.
Why PE Ratios Can Be Misleading
From a valuation perspective, many pundits cite market price-to-earnings (PE) ratios as an indication of a frothy market. Simply put, the higher the PE ratio, the more investors are willing to pay for each dollar of annual earnings. While PE ratios are extremely important and widely-employed valuation metrics, misleading inferences can be drawn from superficial examinations.
For instance, different conclusions can be drawn depending on what earnings number is used in the PE calculation. The current trailing 12-month S&P 500 PE ratio stands at 22.9, markedly higher than the historical average of 15.7. But, because corporate earnings are rapidly growing, on a 12-month forward basis, the PE ratio is a much more modest 17.8.
Other analysts point to seemingly high levels of the Cyclically Adjusted PE (CAPE) ratio, developed by Nobel Prize laureate Robert Shiller as an indication of just how overvalued the current market appears. CAPE is based on average inflation-adjusted earnings from the previous ten years and is intended to smooth out fluctuations in corporate profits that occur over different periods of the business cycle. The CAPE ratio currently stands at 31.7, nearly double its historical average of 16.6. But, CAPE is historically high because earnings from the financial crisis and immediate post-crisis period are part of its calculation. The ratio will decline as the dismal earnings years of the crisis are replaced by the robust earnings years of the most recent past. Had Shiller settled on an eight-year earnings average instead of a ten-year average, the numbers would look markedly different.
Looking Beyond the PE Ratio
When attempting to determine if stocks are overvalued, one needs a comparison metric. If it is strictly by PE against history, it is easy to conclude that stocks are overvalued. However, historical norms are the wrong metric.
Simply put, stocks compete with bonds for investors’ dollars. When bond yields are high, stocks must have high expected returns to entice investors to buy them. Conversely, when bond yields are low, investors can be seduced into buying stocks much more readily.
The ten-year US government bond is currently selling to yield around 3.2 percent. It is essentially selling at a PE ratio of 31.3 times. Now, would you rather buy a diversified basket of stocks, with rising corporate earnings and dividend yields, selling at 22.9 times earnings or would you rather lock in a ten-year government bond return of 3.2 percent per annum? The choice seems clear.
Take It From Warren Buffett
By the way, don’t take it from me, but from Warren Buffett. In an interview with CNBC’s Becky Quick last year, the Oracle of Omaha said “The most important item over time in valuation is obviously interest rates. If interest rates are destined to be at low levels, it makes any stream of earnings from investments worth more money. The bogey is always what government bonds yield.”
Those predicting a future bear market are, without question, correct. That is to say with 100 percent certainty, we will eventually experience another bear market. The case is not obvious that it will be sooner rather than later.
Robert R. Johnson, PhD, CFA, CAIA, is a Professor of Finance in the Heider College of Business at Creighton University in Omaha, Nebraska. He is co-author of the books Strategic Value Investing, Invest With the Fed, Investment Banking for Dummies, and The Tools and Techniques of Investment Planning.