U.S. stocks have staged an epic comeback in recent
days with the S&P 500 now up over 10% for the year. If the gains
hold, it will be the third straight year of double-digit stock market returns.
That hasn't happened since the late 1990s. But wise investors are always
looking ahead, and the inevitable question now is: are stocks overvalued?
A look at the
numbers: The classic way to measure whether stocks are cheap or not is
to look at the price-to-earnings ratio for the S&P 500. It's a gauge of
whether corporate earnings actually justify the stock market level.
The PE ratio is currently at 19, according to S&P
Capital IQ. That's above the historic average of 15, although not too far off
from the average of the last decade, which is nearly 17. To put it bluntly, the
PE certainly isn't in Black Friday discount territory, but it doesn't exactly
scream swindled, either.
The bearish case: Market
pessimists often point to what is known as the Shiller PE after Nobel Prize
winning economist Robert Shiller. He takes the PE ratio and makes some
adjustments for inflation and average earnings for the past decade. It's akin
to looking at calories from fat instead of just calories.
According to the Shiller PE, stocks are pricey. We're now at
26.5 by his measure compared to the historical average of 16. The height of the
dotcom bubble saw the Shiller PE shoot up to 44, while the worst of the Great
Recession saw the ratio bottom out at 13. Shiller himself has warned that we
might be in another bubble.
Other considerations: But
there are two other key factors to think about when judging stock prices:
First, how fast is the economy growing and second, is the Federal Reserve
likely to make a mess?
Optimists admit that U.S. stocks aren't cheap right now, but
they see that shares are pushing higher for a logical reason: American
companies and the economy are clearly expanding. The latest corporate earnings
came in strong despite headwinds from Europe, Ebola and ISIS, among others. All
10 S&P 500 sectors are growing and about 75% of companies beat
expectations.
The U.S. economy is still chugging along with this year's
GDP expected to be a bit above 2%. All of that points to a pretty solid
state of affairs.
The big question
mark: Stocks typically go into a tailspin because there is some
gigantic mistake. Inflation gets out of control or the Federal Reserve moves
too quickly to raise interest rates, for example.
At the moment, inflation is 1.7% -- lower than the Fed's
target of 2%. The market is certainly fearful of the central bank's intended
interest rate increase in 2015, but Fed Chair Janet Yellen and her fellow board
members are giving as many signals as they can about what's going to happen and
when.
Stocks are certainly on the expensive side, but as Shiller said
it's not a bad investment, all things considered.
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