Are U.S. Stocks Expensive?

One way to measure whether stocks are expensive is to compare the current price of the stock to the underlying earnings of the company. This is known as the Price-to-Earnings or PE Ratio. If the PE Ratio is high, then you have to pay a high price for a given amount of earnings, so you could say that the stock is expensive.

The Shiller PE Ratio is a better measurement:

Unfortunately, the simple PE Ratio can vary dramatically because of inflation and recessions in the business cycle.  In order to account for this, economist Robert Shiller of Yale University invented what has become known as the Shiller PE Ratio. (It is also called the CAPE Ratio, for Cyclically-Adjusted Price-to-Earnings Ratio).  Shiller included:

1. The 500 largest US companies that make up the S&P 500 Index.

2. Earnings from the most recent 10-year time frame.

3. Adjustments for inflation and variations in the business cycle. 

Shiller PE Ratio from 2000 to 2020 (Reference #1)

This chart shows that the Shiller PE Ratio (at 32.7 in mid-November, 2020) is near the highest it has been in the past 20 years, and almost double the All-Time Historical Average of 17.1. You can find the latest Shiller PE ratio at https://www.multpl.com/shiller-pe

According to an analysis by Michael Finke, the Shiller PE Ratio has explained 85% of the future returns of the S&P 500 Index since 1975.  This means that if the Shiller PE is high, the stock market returns over the subsequent 10 years tend to be low. If the Shiller PE is low, the future returns tend to be high.  At the current Shiller PE level of 32.7, Finke predicts that the S&P 500 will have an average annual return of only 3% to 5% over the next 10 years (#2).  This is approximately ½ of the historical average return of over 8%.   By this measure, U.S. stocks (specifically the S&P 500 Index of stocks) are quite “expensive”.

Consider your Alternatives

Although stocks look expensive historically, a possible 3% to 5% return over the next 10 years can still look attractive when compared to the interest rate promised by 10-year Treasury bonds which has been under 1% since March 2020. There is always a trade-off between risk and return in investing.

Bottom Line:

With interest rates on lower risk assets, like bonds and CDs, at historic lows, the current high stock valuations (as shown by the current Shiller PE Ratio) can look acceptable.  This thinking even has an acronym in financial circles: T.I.N.A. = There Is No Alternative.

References:

1. https://www.gurufocus.com/shiller-PE.php

2. Michael Finke, a professor of wealth management at the American College of Financial Services, “”The Remarkable Accuracy of CAPE as a Predictor of Returns” https://www.advisorperspectives.com/articles/2020/07/20