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Are stocks still cheap?

August 5, 2013

Anyone who reads this blog regularly knows my worries about stocks being overvalued. For some time now, I’ve been pointing out that the market’s current heights are likely to be unsustainable. In the interests of fairness, it’s worth pointing out that, while I have cautioned (and continue to caution) investors about the dangers of a stock market bubble, there is a line of thought out there that suggests almost the exact opposite. High Frequency Economics’ Jim O’Sullivan recently wrote the following:
 

“Based on estimated Q2 operating earnings, the S&P 500 P/E is around 16, which implies an earnings yield of just over 6 percent; the earnings yield is the inverse of the P/E. That is down from over 8 percent at the peak in late 2011 but still above the 5.5 percent average from 1988 to 2008. The implication: There is still some room from a valuation perspective for equities to rise more than profits.”
 

I bring that up to show that, depending on which index you are looking at, stocks can seem high or low relative to their value. But my convictions have not changed, and here is why. First, when interest rates rise (and they have nowhere to go but up), it will slow down the economy across the board. Second, what I consider to be a far more accurate and reliable metric, the Shiller P/E (price-to-earnings ratio) paints a far bleaker picture than the one suggested by Mr. O’Sullivan.
 

According to the Shiller P/E, stocks have only been more overpriced twice before in history: in 1929 and in the late 1960s—and both times were immediately prior to long bear markets. The long-term average for the Shiller P/E is 15.8. In 2009, the Shiller was around 9. Today, it’s at nearly 25. That is not good, folks.
 

Metrics aside, the bottom line is that I do not think the market is being guided/driven by fundamentals right now. And when economic realities do come home to roost and interest rates go up, money will not be quite so available. That raises the cost for companies to do business, it raises mortgage rates—almost everything is impacted when interest rates rise. And that includes the market.

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