Are U.S. Stocks Expensive?
By Dr. Hassan Shirvani—-As U.S. stock prices reach new historic highs, many investors are now wondering if another stock market cycle of boom and bust is at hand. Indeed, many financial advisors are already recommending a shifting away from stocks into safer investments such as cash and bonds. While predicting future stock price movements is a foolhardy task, it is still possible to question some of the prevailing arguments for an imminent and sharp stock market reversal.
Using Stock Valuation Measures
Judging by conventional stock valuation measures, such as price/earnings multiple (PE), cyclically adjusted price/earnings multiple (CAPE), and dividend yield, U.S. stocks are certainly not cheap, although they are not absurdly expensive either. For example, the current stock market PE, based on twelve months of trailing reported earnings, is about 24, a rather elevated, though by no means dangerous, level compared to its historical average of around 16. (In contrast, the market PE was 44 during the peak of the 2000 tech bubble and 124 in the aftermath of the financial crisis.) Still, under normal conditions, even a PE of 24 should excite some anxiety about the US stock market being expensive.
The current conditions, however, are far from normal. This is easily seen through the fact that the major determinants of the stock valuation measures, such as interest rates and corporate earnings growth rates, are currently significantly different from their normal levels. Thus, given the exceptionally low current interest rates and the very high current earnings growth rates, the observed elevated levels of stock valuation measures are to be expected. Indeed, given the historically low current bond yields, one could plausibly argue that, if anything, it is bonds and not stocks that are relatively expensive. Looked at differently, while the current PE for the stock market is about 24, it is around 45 for the 10-year US Treasury notes. Since historically these multiples have been about 16 and 20, respectively, it is clear that investors are presently paying relatively too much for bonds. Under these conditions, the sound advice will seemingly be to move away from bonds into stocks, rather than the opposite.
It is, of course, possible that current low interest rates, far from a temporary aberration, may turn out to be quite long lasting, reflecting perhaps a new normal state of weaker economic conditions and, hence, dimmer prospects for corporate earnings and their stock prices. If, true, this fact will render stocks quite pricey indeed. However, the very strong current and expected earnings growth rates tend to raise serious doubts about this possibility. In addition, the current low interest rates are more likely a result of the massive monetary interventions by the Fed to alleviate the effects of the recent financial crisis. Once these interventions are reversed, interest rates are likely to attain their former higher levels.
Relevance of Time Periods
On the other hand, the average historical values of many of the stock valuation measures also depend on the duration and occasion of the time periods considered. For example, the average stock PE for the past century is close to 16, while for the past two decades it is close to 26. Under these conditions, one should decide whether one or the other of these two periods is more relevant for our current stock market valuations. In particular, while a current PE of 24 renders stocks expensive by the former average, it renders them somewhat cheap by the latter. Needless to add, one could plausibly argue that the last two decades are probably more relevant, since the present U.S. economy shares more traits with the economy of the last 20 years than with that of the preceding 80 years. In particular, and even ignoring the amazing technological innovations of the past two decades, there are far fewer shares on the market due to recent trends towards greater business concentration, company share buybacks, and fewer initial public offerings. (The number of public US companies is now roughly 3,500, as compared to almost 7,000 two decades ago.) With fewer outstanding shares, one could expect an increase in stock prices, given the steady growth in demand for US equities.
Relevance of Earnings Numbers
Finally, many of the existing valuation measures are also affected by the properties of the underlying earnings numbers used. For example, for companies with high internal investments, and therefore with low reported earnings or distributed dividends, such as Amazon or the early Microsoft, these measures are going to display abnormally high values, thus rendering these companies seemingly too expensive. In fact, however, such companies have mostly turned out to be highly lucrative long term investments. In addition, and in the light of the sharp drop in corporate earnings during the latest economic crisis, it would not be surprising to see relatively high CAPE multiples, given that this multiple is based on a 10-year moving average of those earnings. As companies mature and as economies gradually return to more sustainable growth rates, corporate earnings will tend to normalize, resulting in more conventional levels of stock valuation measures. In addition, it is well known that the GAAP earnings numbers, as traditionally used to calculate CAPE, are generally more conservative than reported earnings and can therefore result in artificially higher CAPE multiples.
In summary, while conventional stock valuation metrics do have their uses, investors must exercise great caution in their applications to avoid pitfalls in their investment decision makings. In particular, superficial comparisons of the current levels of these metrics with their historical averages can sometimes hide more than they reveal about whether or not stocks are correctly priced. In this light, the current warnings about an overheated stock market should therefore be taken with a grain of salt. At the same time, however, a number of adverse factors, such as a sharp increase in interest rates, a general investor disappointment with the pace of the expected tax reform and government infrastructure spending under the Trump administration, and an unexpected geopolitical crisis, may still serve to negatively impact business prospects and investment sentiments, thus resulting in a sharp stock market correction.
Hassan Shirvani, Ph.D.
Professor Cullen Foundation Chair in Economics