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Sunday, March 1, 2009

Is the Stock Market Cheap?

*I believe the P/E ratio should be between 5 and 8. That would be a more realistic ratio based on the current economic conditions coupled with the sheer lack of earnings. Based on the Dow futures trading at 6962.00 tonight, we are getting closer and closer. 6200 will likely be the next low.

February 28, 2009
An old-fashioned way to answer this question is to look at the historic P/E ratio. Over the past 137 years, the average P/E ratio is 15. At the end of February 2009, the P/E was 28.1.

Yale Professor Robert Shiller, author of Irrational Exuberance, smoothes the P/E calculation by using the earnings average of the previous ten years as the divisor (see p. 5-6 of his book). With this method, the historic P/E average is 16.3, with a February monthly close P/E10 at 13.0.

An overlay of the traditional P/E and Shiller alternate shows that the Shiller method is a more logical fit with historic index prices. However, by either method, the market appears to have been overvalued for most of the past two decades. For the market to move into bargain territory, something must change. Earnings must rise or prices must fall — or we get a combination of the two.

Of course, the historic P/E has never flat-lined on the average. On the contrary, over the long haul it swings dramatically between the over- and under-valued ranges. If we look at the major peaks and troughs in the Shiller P/E10, we see that the high during the Tech Bubble was the all-time high of 44 in December 1999. The 1929 high of 32 comes in at a distant second. The secular bottoms in 1921, 1932, 1949 and 1982 saw P/E10 ratios in the single digits.

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