One of the only measures of stock market valuation that shows a strong tendency toward long-term mean-reversion–the cyclically adjusted PE ratio–suggests stocks are now about 15%-20% overvalued.
This, of course, is nothing new: Stocks were overvalued on this measure for most of the two decades from 1990 to 2007. (They dropped below fair value for a few minutes in 2003, before blasting off to the moon again).
Now, thanks to the S&P’s 58% rise off the bottom, stocks are now trading at 19X Robert Shiller’s cyclically adjusted PE ratio.* This compares to an average of about 16X for the past 130 years.
Keep in mind that this level of over-valuation alone does not herald a near-term reversion to the mean: Last time this PE ratio soared past 20X, for example (in 1992), it stayed above 20X for 16 years. It is also possible that the “average” PE ratio has shifted upwards over the past century and that the “new normal” is something closer to 20X.
Unless we really have hit a new normal, however, the cyclically adjusted PE ratio does suggest that the long-term return on stocks from this level will be less than the long-term average. Specifically, it suggests that stocks will return about 4% real (after adjusting for inflation) over the next decade, versus the 7% average).
* The cyclically adjusted PE ratio (CAPE) averages the past 10 years-worth of earnings to smooth out the impact of the business cycle. Profit margins are mean-reverting, which means that high profit margins tend to fall and low profit margins tend to rise. As a result, a straight one-year PE ratio can give a misleading impression of value. At the peak of the business cycle, when profit margins are high, the PE ratio looks artificially low–and vice versa. Robert Shiller’s cyclically adjusted PE provides a much more stable denominator.
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