Why the Stock Market Is Over-Valued
Economist Dean Baker, commenting on the following articles (Jan. 5, 2004):
Market Caps Off Sustained Rebound
Ben White and Carrie Johnson
Washington Post, January 1, 2004, Page E1
Year’s Big Rally Helps Investors Regain Ground
New York Times, January 1, 2004, Page A1
Energized by the Economy, Small Stocks Lead the Way to Big Gains
New York Times, January 2, 2004, Page C1
These articles report on the stock market’s performance in 2003 and assess the prospects for 2004. The articles report that the market’s prospects for another strong year in 2004 are good, based on predictions that the economy will be healthy.
None of these articles ever mention the price to earnings ratios of the various market indexes. The price-to-earnings ratio is the most important measure of the stock market’s value indicating whether it is currently undervalued or overvalued compared to historic patterns. Discussing the stock market’s value without making reference to its price to earnings ratio is comparable to assessing the value of an apartment building without ever considering how much rent it generates. For a sports analogy, this is like assessing running backs in football without ever considering their average yards per game or per carry.
Historically, the price-to-earnings ratio for the stock market as a whole has averaged approximately 15 to 1. If the price-to-earnings ratio were considerably higher than this (e.g. it hit a bubble peak of 33 to 1 in March of 2000), then an investor would be foolish to hold stock even if the immediate prospects for the economy were very bright. Alternatively, the price to earnings ratio has sometimes been under 10 to 1, as was the case in the mid-seventies. In such situations, the stock market is likely to provide good returns, even if the economy is not performing very well.
At present, the ratio of price to trend corporate earnings is approximately 20 to 1. At this ratio, investors can anticipate lower than normal returns over the long run. Historically, stocks have provided an average real return of 7 percent annually. If the price to earnings ratio remains at 20 to 1, then investors can anticipate average real returns of approximately 5 percent annually (see “Stock Returns for Dummies” [http://www.cepr.net/stock_market/Stock%20Returns%20for%20Dummies.pdf].
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