Probably, before the first investment strategist was ever born, investors were asking if the stock market was over-priced and headed for a collapse. Today, the most common response is in terms of the price-earnings (PE) ratio. It is the same as the PE ratio for individual stocks. You take the market price of the stock and divide it by the earnings-per-share (EPS) for that stock. Tallying up all the stock PE ratios, you find the overall market's PE ratio.
Looking at this chart, you can see the market's PE ratio has broken above an important resistance line, which is 22 times or 22X. This suggests the stock market is indeed over-priced and headed for a fall.
Looking at this chart, you can see the market's PE ratio has broken above an important resistance line, which is 22 times or 22X. This suggests the stock market is indeed over-priced and headed for a fall.
Of course, nothing is ever as simple as it first appears. This chart looks at earnings in the rear-view mirror. As EPS have dropped slowly for the last five quarters, the simple arithmetic has driven up the PE ratio. Now, most strategists expect EPS to start rising this quarter, which will decrease the market's PE ratio, hopefully back below 20X.
Another argument is that PE ratios were a useful benchmark when we had a "free market economy" instead of a "monetary policy economy." which is driven by the Fed. Frankly, I think that lends too much significance to the Fed's actions, but it is clear that abnormally low interest rates do boost EPS and increase demand for those stocks paying dividends.
This is called the "TINA" stock market, meaning There-Is-No-Alternative to stocks. If investors want income, they have to buy stocks, since bonds pay less than stocks. This alone will push the PE ratio above the resistance line.
So, is the stock market over-priced? Yes, based on current earnings, but not by much. No, based on projected earnings. Is the sky falling? No, not today . . . but tomorrow is always another day!
