Just how far out of line is the S&P with earnings and sales?

Robert Shiller (Petras Malukas/AFP/Getty Images)

Stocks are overpriced. This article will look at three ways to answer the question of just how much.

Where do we go with this? Not to a declaration that you should sell all, in anticipation of a bear market. It’s impossible to time your way around a bear market. My aim is more modest. It is to temper expectations.

Lowering expectations should cause present and future retirees to alter their behavior in two ways. They should, first of all, take another look at whatever return assumption is built into a retirement plan. That number is probably too high. Prudence calls for spending less and saving more.

The other thing investors need to do, in an era of historically rich stock prices, is to think about what they might do if and when a crash arrives. I can think of three friends who sold all or most of their equities during the last crash. They turned a temporary misfortune into a permanent one.

If you are 30 and iron-willed, maybe you will shrug off a 40% correction, and so there’s a case to be made for having your 401(k) 100% invested in stocks. But if you are like most investors, you need some bonds as an anchor. The overvaluation makes a pullback more likely now than it would normally be and at greater risk of being severe.

So, don’t make a drastic move. But do put your allocation to equities at the conservative end of your normal range.

Measure I: Cape

Robert Shiller made the “cyclically adjusted price/earnings” ratio famous. It’s equal to the S&P 500 index price divided by the index’s average annual earnings over the past ten years. Historical earnings are adjusted for inflation.

Shiller’s formula has what I see as a flaw that overstates how pricey the market is. But not by a huge amount. We come to the same conclusion: Stock valuations are abnormally high.

The problem with Cape as conventionally defined is that it is warped by dividend policy. Corporation A pays out most of its earnings in dividends and so its earnings per share figure grows slowly. Company B, otherwise identical, disburses earnings by buying in shares. (A buyback accomplishes the same thing as a dividend except that it lowers the tax burden on shareholders.) B’s EPS grows rapidly as its share count shrinks. That means its trailing ten-year average of EPS will get pushed down.

If A and B have the same valuation, which they should, A and B will have the same one-year price/earnings ratio but B will have a higher ten-year Cape ratio. This wouldn’t matter in the evaluation of an index if dividend paying habits stayed the same over a century—if, that is, the same mix of A-style thinking and B-style prevailed. But they haven’t stayed the same. In recent years share buybacks have overtaken dividends as the preferred means of distributing excess cash. So the S&P’s Cape should be a bit higher now than it was 50 or 80 years ago.

To make today’s ratios more comparable to 20th century ratios I created an imaginary company that bought one S&P unit in December 1926 and reinvested all dividends in more S&P units. (Why 1926? Because stock data before then is sketchy.) Then I calculated the Cape for this company. All the raw data came from Professor Shiller’s website.

I made one other change: I pushed the ten-year measurement period forward a year. Using nine years of history and one year of divination to come up with a ten-year average, I had Capes beginning in December 1935. To get a Cape for the current market, I took at face value the analyst forecasts for S&P earnings through June 2019.

The Cape on Shiller’s website is 32 today. It peaked at 44 during the dot-com silliness at the turn of the century. It has averaged 18 since the end of 1935, and on that score stocks seems to be 78% too high right now.

My current Cape of 30 compares to a post-1935 average of 20. Our two formulas agree that the market is overpriced, but mine says it’s only 50% overpriced.

Measure II: Market Versus GDP

In 1975, you could purchase all the publicly traded stocks in the U.S. for a sum equal to 40% of that year’s gross domestic product.

Today, your tab, per dollar of GDP, would run four times as high.

Some of this explosion in stock prices is justified. There is not as much malaise in the air, and not as much stagflation, as there was in the 1970s. Corporate profits as a percent of the country’s economic output are higher. Real interest rates are lower, making financial assets more valuable.

But still, that fourfold jump is quite something. The stock market is stretched.

Measure III: Price to Sales

Standard & Poor’s publishes sales for its 500 index, beginning in late 2010. The ratio of price to trailing 12-month sales is shown here:

The ratio has almost doubled in seven years. Why?

One reason is that profit margins have widened, as corporate America skimps on taxes and wages. The other reason is that Wall Street is exuberant in its expectation that the margins will continue to widen.

Conceivably they will. Conceivably a future Congress will hand out still more corporate tax cuts, and future employees will accept wages that are even more miserly.

More likely: The trends will go the other way.

There you have them: three pieces of evidence that the market is getting a little crazy. I repeat my caution that we cannot know in advance the timing of a correction, or be sure that stock prices will resume ratios that are in line with historical averages. But we can say that the more prices are stretched, the higher the likelihood that they will snap back. Adjust your behavior accordingly.

Originally published at Forbes

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