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The RetireMentors

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Jan. 3, 2017, 4:15 p.m. EST

Is the stock market overpriced?

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By William Droms

About William

William G. Droms is the co-founder and co-chairman of Droms Strauss Advisors, Inc., a Registered Investment Advisor that specializes in providing wealth management services to high net worth individual investors. He also is the John J. Powers, Jr. Professor of Finance in the McDonough School of Business at Georgetown University, where he teaches investments in the undergraduate and MBA programs. Bill is a graduate of Brown University, holds a Master's and Doctorate in Business Administration from George Washington University and is a CFA charter holder. He is the author or co-author of several books on investments, including Investment Fundamentals, The Dow Jones-Irwin Guide to Personal Financial Planning, The Dow Jones-Irwin Mutual Fund Yearbook, and The Life Insurance Investment Advisor. You can e-mail bill at bill@droms-strauss.com or contact him at droms-strauss.com. Follow Bill on Twitter at @Wdroms.

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Now that we all (or most of us, anyway) have settled in with the election results, it is pretty fascinating to look back at the market action during the fourth quarter of the year: from Election Day on Nov. 8 through the market close on Nov. 30, the Dow Jones Industrial Average /zigman2/quotes/210598065/realtime DJIA -0.16%  rose 790 points to 19,123 (+4.3%) and the Standard and Poor's 500 Index /zigman2/quotes/210599714/realtime SPX -0.20%  climbed 68 points to 2,199 (+3.2%).

Since then we have seen a succession of new highs on both indexes, vaguely reminiscent of the tech bubble of the late nineties when one prescient observer noted that the market discounts the future, but at that time, appeared to be discounting the hereafter as well. Except, maybe it really is different this time . . . and maybe not.

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A reasonable take on the U.S. equity market is that the market is definitely pricey, but perhaps for good reason. The very long run average of the S&P 500 Price to Earnings (PE) ratio (since 1900) is approximately 15.8, and the ratio since 1946 (the post-World War II period) is 17.3, so let's call a "normal" PE ratio about 16.5. This is the normal ratio based on trailing twelve month's (TTM) earnings, not the usually lower ratio based on an estimate of "forward" or forecasted future 12 month's earnings. Given the difficulties of forecasting future earnings, and ignoring the illusory precision of calculations based on past earnings "as reported" in corporate annual reports, let's stick to the facts of actual reported earnings for the previous 12 months. By this measure, the current (as of 12/29/16) TTM EPS of the S&P 500 stands at 25.89, which we can fairly call 26. This puts the current PE ratio nearly 60% higher than average, which is perhaps about double the range of "pricey."

Readers of the financial press may now ask: "Well, what about the Shiller PE ratio?" The Shiller PE, named after Nobel Prize-winning economist Robert Shiller of "Irrational Exuberance" fame, which is often abbreviated as "PE10," bases it calculation of PE ratios based on the ratio of the current level of the S&P 500 to the trailing 10-year average inflation-adjusted earnings of the companies comprising the index. The very long-run average (since 1871) of the Shiller PE is 16.7, very close to our estimate of a normal TTM PE ratio. The post-World War II Shiller PE average is 18.7, a good bit higher than the TTM ratio and the very long run Shiller ratio. However, the current level of the Shiller PE at 26.8 is about 60% higher than the long-run average, and 53% higher than the post-World War II average. Surely this observation should give one pause — except, the Shiller PE has been above "average" for most of the last 25 years. In fact, it has been below average only once since 1992 (in 2009 the year of the credit crisis crash).

So now we pause to consider the impact of very low interest rates on stock valuations and the further impact of inevitably rising interest rates next year on stock valuations. A seemingly benign idea called the "Fed Model" has attracted some controversy over the years as to the validity of the model (for a concise academic discussion, one may read an NBER working paper from 2009 entitled "Inflation and the Stock Market: Understanding the 'Fed Model'"). A brief intuitive explanation of the model, which has never in fact been endorsed by the Fed but has been referenced in various Fed pronouncements, simply states that the reciprocal of the PE of the stock market (the E/P or earnings yield) can be usefully compared to the yield to maturity of the 10-year government bond. The "theory" behind this, if it is in fact a theory, is that if the 10-year bond yield is say 2.5% (about where it is now), then investors should be willing to pay a price for stock earnings that also yields 2.5%. Thus, in the current market, a "fair" PE to pay for stocks would be about 40 (1/.025), i.e., a PE multiple of 40 results in an earnings yield (EP ratio) of .025 or 2.5%.

So, based on the Fed model, the current extremely low interest rate environment flows through to higher multiples for stock earnings. This approach, to me at least, has some intuitive appeal: it essentially says that if investors are willing to pay 40 times a stream of guaranteed, but fixed, interest payments to own a Treasury bond, they should also be willing to pay 40 times a stream of uncertain, but growing, earnings to own a diversified portfolio of common stocks (i.e., the S&P 500). There also is some empirical support for this position as charts of the 10-year Treasury yield and the S&P 500 earnings yield often follow each other quite closely.

Of course, interest rates are nearly certain to go up over the next few years and increased rates should flow through to the Fed Model PE ratio. If the 10-year rate goes to 4.0%, this implies a fair value ratio of 25 (1/.04), which is about where the current TTM PE resides. A PE of 25 thus may be seen as definitely pricey compared to historical averages, but perhaps justified by the current era of very low interest rates. One thing we do know, however, is that the current level of PE ratios, whether TTM, forward or Shiller, has been shown to be a poor guide to market timing. This knowledge brings us back to the "old time religion" — buying and holding a diversified portfolio commensurate with your personal risk tolerance is the best defense against uncertain markets.

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