Here's an interesting analysis that should not be overlooked. Charles Lieberman here at Bloomberg View looks at whether the stock market is overvalued. He concludes it is not, but it’s his analysis, based upon a dividend discount model, that I want to point out. It is a much more nuanced case for moderate stock valuations than the Wall Street Journal's recent argument that, in the wake of oil's collapse, stocks are cheap.
As Lieberman observes of the price-earnings ratio:
Since 1954, the S&P 500 P/E trailing multiple has averaged about 16.6. But this encompasses very high P/E periods, such as the 1950s and the 1990s and exceptionally low P/E periods, such as the 1970s.
Rather than merely use the median, why not try to find similar periods so as to make a better comparison? He concludes:
If we focus on those periods when inflation and interest rates were low, as they are today, the implied equilibrium P/E multiple is well above the historical average, but also above the prevailing multiple in today’s market.
Thus, adding in those additional variables -- interest rates and inflation -- provides context that might change how you value equities.
There are many ways to value stocks, none of which are perfect. We reviewed a list of 15 such measures a couple of years ago, via a report from quant strategist Savita Subramanian of Merrill Lynch. The conclusion then was that U.S. stocks were somewhat pricey, but not terribly so.
Lieberman’s observations reminded me of a few simple rules I have accumulated about valuations. It is too easy to forget these:
Ritholtz’s Rules of Valuations
1. Overvalued stocks and markets can continue to get overvalued, often for a long time. (Think back to 1996, when so many strategists became cautious. Markets powered higher for four more years.) Cheap stocks can get even cheaper.