Tuesday, September 24, 2019

Is the stock market over-valued?

Historically (link), Shiller's P/E ratio (CAPE) looks high (Sept 24, 2019) but if I really knew I wouldn't be teaching school...and I probably wouldn't tell you.

Investopedia reports what Shiller (bubble-ologist) says:

The developer of the CAPE ratio, Nobel Laureate in economics Robert Shiller of Yale University, has been warning that current market valuations are unsustainable for the long run, as discussed in another Investopedia report. He is particularly concerned about "the public's lack of healthy skepticism about corporate earnings, together with an absence of popular narratives that tie the increase in earnings to transient factors," as he has written in an essay republished by MarketWatch.

5 comments:

  1. Great article, thanks for sharing this valuable information
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  2. I think it's easier to understand what's going on if you plot CAPE vs interest rates since the early 80s.

    More leverage should increase valuations (if for no other reason than that it changes the leverage that a private buyout firm could put on the asset to take it private); lower rates should drive more leverage as firms can carry more debt at the same interest cost (so higher ratio of debt to EBITDA).

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  3. This is very interesting because I've been doing some research on inequality using the Shiller PE index.

    From 1880 to approximately 1980, the Shiller PE stayed within a range:

    https://imgur.com/a/wP4C3wh

    That image is the data from the same chart Prof. Froeb posted, with mean and +/- one sigma lines added.

    Roughly in 1980, Something Changed. I suspect growing inequality due to US tax policy after Reagan's 1981 tax cuts.

    Notice that since 1980, the Shiller PE Index has had a growing trend. Stock valuations are "overvalued" by historical measures and keep getting higher.

    Also notice that, even at the bottom of the Great Recession, the stock market was only *slightly* undervalued compared to it's long-term mean. Which suggests that stock prices may not fall as much as some home when the next recession hits.

    If you compared the Shiller PE against the 10 year US Treasury yield:

    https://fred.stlouisfed.org/graph/?g=p08l

    You'll notice that bond yields have been falling since pretty much the exact same time that stock market valuation started growing.

    I believe the falling bond yield represents a "savings glut" due to inequality. A "savings glut" has grown faster than the available investment opportunities. Econ 101, when supply exceeds demand, prices (in this case yield) falls.

    I'm not sure if Shiller PE represents the same thing applied to the stock market, or a side effect of the bond market. I suspect investors are "reaching for yield" in the stock market, paying a premium for each dollar of earnings because bond yields have been falling.

    I'll have a long blog post about this in a few more weeks. Of course, I said that a few weeks ago, and the more I study it, the more interesting the problem gets.

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