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Are Stocks Cheap Or Expensive Right Now? Maybe Neither

Filed by KOSU News in US News.
August 10, 2011

Forget, if you can, the day-to-day craziness in the stock market. Here’s a broader question: After the big declines of the past several months, are stocks cheap? Are they still expensive?

By one measure, stock prices are not particularly high or low — they’re valued very close to their 50-year average, as Jason Zweig pointed his latest WSJ column.

(Note: This is not a prediction about what stock prices are going to do. I am proud to say that I have no idea what stock prices are going to do. Still, I find this to be a useful way of thinking about how the stock market behaves in the very long term.)

I’ll start with a chart, then explain what it means.

If you know what this chart means, you can stop reading here. If not, here’s an explanation.

When you buy a share of stock in a company, you’re buying a tiny slice of the company’s future profits. So the price of a stock today should be the present value of all those future profits.

Of course, no one knows what those profits will be, and the market isn’t as simple as that explanation suggests. The market plunge in the past few weeks doesn’t mean that investors calmly, rationally decided that all future profits of U.S. companies will be radically lower than they previously thought.

Still, it’s useful to keep this idea in mind, particularly over the long term. Investors have developed a measure to track the price of a company’s stock relative to its profits, or earnings. It’s called the price-to-earnings ratio, or PE.

Quick example: Say Planet Money International stock is trading at $50 a share, and Planet Money’s annual profits are $2 per share.

To get the PE, you divide the stock price by the annual income. In this case, you divide 50 by 2. The PE for Planet Money international is 25.

A higher PE means investors are willing to pay more for each dollar of current profit — typically a sign that investors think profits will grow in the future.

PE is sometimes calculated by using profit estimates for the coming year. But these estimates are notoriously unreliable. You can also use the previous year’s profits to calculate PE. But profits can bounce up and down a lot from year to year.

Robert Shiller, the Yale economist, uses a PE measure that takes into account the past 10 years of profits. That has the advantage of smoothing out the year-to-year ups and downs.

He’s calculated this measure — known as the cyclically adjusted PE — for a broad swath of the U.S. stock market going all the way back to 1900. (Here’s the spreadsheet.)

Over the past 50 years, the average cyclically-adjusted PE for the overall stock market has been 19.5. As I’m writing this — it’s Wednesday morning, and the S&P 500 is at 1140 — the cyclically adjusted PE is 19.7. (The last data point chart above reflects yesterday’s close, by the way.)

Again, this isn’t a prediction about what the market is going to do. It clearly moves widely around the long-term average. And for that matter, the long-term average can change over time.

Still, looking at the market in this way can make it easier to see beyond the day-to-day craziness of market moves and think about the long-term picture. [Copyright 2011 National Public Radio]

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