How do you measure the stock market’s value?

This is a question that many investors ask, and we wanted to help you measure if and when the stock market is overvalued. If you’re an investor, it’s always prudent to ask yourself if stocks are overvalued before you buy… but how can you actually be sure? Most investors use the universally accepted price to earnings ratio (P/E ratio).

• So… What is a P/E ratio?

The price to earnings ratio is the most traditional method for evaluating the valuation of the stock market. If you ask the average broker or market commentator where the stock market is currently valued, it’s almost a guarantee that they will reference the P/E ratio. If you asked most advisors today you will likely hear along the lines of, “the P/E ratio is right at or just below historical averages, so right now the market is not expensive, not cheap, but probably priced about right.”

• Ok… Then how is the P/E ratio calculated?

It’s pretty simple actually… you take the price of a stock or a stock index and you divide it by one year’s (last year’s) earnings. This is where we start to get concerned. You see, the glaring issue with calculating it this way is that it only takes into consideration 1 year’s worth of earnings data. 1 year!? Have you ever heard of any business that had the exact same earnings year to year? We haven’t either.

• Are there any alternatives to the traditional P/E ratio?

Dr. Robert Shiller of Yale University actually won a Nobel Prize when he pointed out the flawed nature of a ratio that only considers 1 year’s earnings. He made the point that because most businesses are cyclical (earnings go up and down all the time), a P/E ratio that only takes 1 year of data into consideration is most likely missing the bigger picture. What was his solution? He created the Shiller P/E ratio which is basically the same calculation only it uses an average of the last 10 years of earnings as the divisor. Using this 10 year average, Dr. Shiller hoped to smooth out the business cycles and give a much more accurate representation of if the market was fairly valued or not.

• How accurate has each indicator been at measuring market valuation?

Well, back in 2009 when the market was making its lows during the great recession (and in hind sight we can all see now that stocks were way undervalued) the traditional P/E ratio told us that stocks were extremely expensive and overvalued. The P/E ratio then was 125, way above the “historical average” of 16. Compare that to the Shiller P/E ratio which back in 2009 was 13… which was a “buy” signal. By just that example, we can see that smoothing out the earnings number by taking a 10 year average gives us a much more accurate measuring stick.

• What does each ratio say about today’s stock market?

The traditional P/E for the market is currently 17… slightly higher than the average of 16, but not by much. The Shiller P/E on the other hand is currently around 25 which is almost 60% above the historical mean. This is really worth the pause to consider caution. Remember, this ratio doesn’t tell us that a market crash is coming tomorrow, but it does highlight the need for investor caution.

So how do you measure the stock market’s value? Cautiously. And with more data than just one ratio based on one year. Please call us or comment below if you have more questions.

Categorized in: Blog

This post was written by Conscient Capital