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Are Stocks Undervalued?
Yale economist Bob Schiller of "Irrational Exuberance" book fame and the Case/Schiller home price index talks about stock market price/earnings valuations here. You'll probably want to spend the 5 minutes watching that before continuing reading below.
Economists and analysts currently disagree over whether stocks generally are undervalued or overvalued just measuring by price/earnings ratios. The reason for the disagreement is that there is not simply one standard of p/e valuations.
There are three simply methods to measure p/e ratios: historic numbers (trailing), the current year's estimates (forward), or a mix of historic and current estimates (median). Historical performance is no guarantee of future performance, but can be used as a guide. "Forward" p/e estimates are always subject to revision... and in this economy, the revision trend has been invariably downward.
Since stock is a share of a company (and thus a share of the earnings if management pays dividends), p/e ratios let you figure how much you pay today for an estimate of future earnings. For the S&P 500 companies, 2009 earnings estimates went from as high as $113 a share last April to $64 today. At $64, the S&P 500 p/e ratio is at 11. Some analysts are estimating as low as $40 a share. At $40, the S&P 500 p/e ratio is around 17.
But if your time horizon for investment is, say, 5 years, you might expect earnings to rebound to prior levels. For example, let's predict that we'll pull out of the recession and have earnings of $128 a share in 2014. I'm personally hoping it will be higher, but it's not much more than the highest 2009 estimates. If you don't mind waiting to share in S&P 500 companies' earnings until 2014, you'd be paying a p/e ratio of 5.5 today. Currently, the ratio is even lower for some individual companies. A p/e ratio of 2-3 is LOW. Of course, there is probably risk that the company's earnings estimates are all over the map.
Schiller advocates another measure -- averaging the past 10 years of earnings. It's called the cyclically-adjusted price-earnings ratio (CAPE). There are problems with this method, too, as a good company's earnings are consistently increasing. So even buying stocks at an "average" historic p/e ratio is a good price if earnings are expected to increase. On the contrary, a risky company has erratic earnings over 10 years, so it's even more difficult to use CAPE as a good measure. (Random analogy: Is it unwise to use CAPE for a stock index when the economy has been erratic over the past 10 years??)
Further, combining two measurement problems - what measure to use and the constantly changing estimates of future earnings - makes it impossible to predict whether a stock market index is overvalued or undervalued. Yet individual companies' earnings and prices are much easier to compare. If a company has an understandable and predictable business, applying these different perspectives can greatly inform you as to that individual stock's valuation. When all p/e measures are below average, then a stock undervaluation is more certain. An index with weighting or average multipliers such as the S&P 500 or Dow Industrials 30 is less certain.
One has to remember that the current economic conditions are not the norm. Investing requires optimism that the future will have better conditions. When signs of a recovery appear and earnings estimates are revised upward, p/e ratios of all measures are going to look even better than before.
Updated: 3/9/2009
That's not "exactly" true. The stock market is a zero-sum game. The market capitalization is the total amount of money that investors/speculators have placed into the "money pot" that we call the stock market. When investors get jitters, they sell their shares and take their money out of the money pot. No money is created or destroyed in the stock market. So when the market drops by $1.2T, it means that investors withdrew that much from the stock market (but not necessarily their brokerage accounts).
comment on Where'd The Money Go?, Jan 13
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