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Some thoughts on current stock market valuation:

First - let's look at Robert Shiller's long-term P/E chart.

The earnings denominator there is based on a 10-year average of earnings. Earnings tend to be quite volatile of course - going up during booms, and down during busts. Stock market investors (not speculators) ideally try to look past that, at the more general longer-term earnings forecasts, and thus at a macro level a smoothed-out version of the earnings over time is good, thus the 10-year average. This is what Robert Shiller does when presenting his long-term P/E ratio.

Looking at that chart - it appears that the stock market valuation is about right - perhaps slightly high, but at just below 20 long-term P/E it’s not too far above the long-term average of 16.

Here’s the problem though. The 10-year average itself is, at least in my opinion, very over-inflated due to the housing bubble. The housing bubble started in 1997, and really was in full swing for a long time - very high for about the 8-year period from 2000-2008. Since house prices were high, a lot of extra equity was withdrawn and pumped into the economy - on the order of $3-5 Trillion or so. This doesn’t include the additional money being pumped into the homebuilders themselves via new mortgage debt.

Thus as a result corporate earnings themselves in the 2004-2007 timeframe reached record levels - by far. They were in record territory for about 4 years actually, and higher-than-normal territory for about 6 years, until plunging to near-record-lows in 2009.

But then note what happened - they shot right back up - fast. Really really fast. Here’s a chart of YoY change in earnings. Not too too incredible, until you expand it out. Wow.

What explains this huge turnaround in earnings in 2009/2010? Simple - this (the dark red line), and this..
What that means is that - unless those two really big stimulus things continue (which aren’t planned), the current level of earnings is not sustainable - because the underlying fundamentals of the economy - the debt load, the foreclosure levels, the unsold housing inventory - have not improved a bit. They’ve stopped getting worse, but they haven’t improved; they’re still at record-bad levels. Now there is a lot less home equity available for the economy to tap into and feed those once-again-inflated corporate earnings. The only place they’re coming from is stimulus - i.e. the TARP, the $862B stimulus package, and the $2T or so of Fed money creation, etc. But all of that is going away over the next few months; officially at least.

Thus unless some more really, really big new “emergency” meaasures are put in place - like on the order of $2 Trillion or so at least - that corporate earnings line is going to go right back down to 30 or below again, and thus going forward the P/E ratio is going to continue going up and up and up - even if stock prices remain level. Note that I’m not proposing that we do this stimulus, just saying what we’re in for. I personally think allowing another crash is the most appropriate action for the long-term health of our economy; we need to unwind our excessive debt, not add to it.

General statement about my posts

I post very infrequently on this blog - really just using it as a repository for information used in discussions on other blogs. I don't visit this blog often, so may not respond to posts in a timely manner.