That said, the problem for traders or others with a less than a semi-decadal timeframe is that these valuation models don't really matter, that crowd psychology is what sets the price in the short to medium term.
From the Peterson Institute's RealTime Economic Issues Watch:
US stock prices rose for seven years in a row through late last year. During that time, the US economy repeatedly underperformed expectations. Popular indicators of stock valuation are above historical norms, even after the declines of the past few weeks. It is therefore no surprise to hear some analysts say stocks are overvalued and we are due for a substantial adjustment. (Somewhat ironically: One of the websites that give (reliable) data on current and past earnings, stock prices, and interest rates, has an ad banner that reads: “Dow to drop 80% in 2016.”)
Are stocks obviously overvalued? The answer is no, and the reason is straightforward. While growth has indeed been weaker than forecast, the rate of return on bonds has also been revised downwards. And what matters for the valuation of stocks is the relation between future growth and future interest rates. Put another way, the equity premium, the difference between the expected rate of return on stocks and the expected rate of return on bonds, has if anything increased relative to where it was before the crisis.
Let’s start with what fuels the fears of some analysts. Perhaps the most widely used gauge of stock valuation is the price-earnings (P/E) ratio, the ratio of a stock’s price to the annual corporate earnings associated with that stock. Figure 1 displays two measures of the average P/E ratio for the firms in the S&P 500 composite equity index. The dotted line is the standard P/E ratio based on reported earnings over the previous four quarters. Because of the unprecedented collapse in earnings during the Great Recession, this P/E measure soared to more than 100 in 2009, literally off the chart. The standard P/E measure reached nearly 22 late last year and is currently around 20, a bit higher than its 60-year average of 19.
A popular alternative measure proposed by Robert Shiller of Yale University uses a 10-year average of past earnings (adjusted for inflation) in order to smooth out temporary fluctuations (the solid line in figure 1). The Shiller P/E measure eliminates the massive spike in 2009 and allows the fall in stock prices that year to show through. Although the two P/E measures were often close to each other in the past, the Shiller measure has been consistently higher than the standard measure since 2010.1 The Shiller P/E ratio reached 26 late last year and is currently around 24, compared with a 60-year average of 20. This elevated Shiller P/E measure is commonly cited as an indicator that stocks may be overpriced, including by Shiller himself.
Note: The Shiller measure adjusts lagged earnings for inflation. The standard measure peaked at 122 in 2009Q2.
As figure 1 shows, the deviations of the P/E from its historical average are in fact quite modest. But suppose that we see them as significant, that we believe they indicate the expected return on stocks is unusually low relative to history. Is it low with respect to the expected return on other assets? A central aspect of the crisis has been the decrease in the interest rate on bonds, short and long. According to the yield curve, interest rates are expected to remain quite low for the foreseeable future. The expected return on stocks may be lower than it used to be, but so is the expected return on bonds....MORE
