Ben Bernanke says that one of his goals with the latest round of quantitative easing is to keep asset prices "higher than they would otherwise be."
Well, it's working!
According to one of the only stock-market valuation measures that works -- Robert Shiller's cyclically adjusted PE ratio (CAPE) -- stocks are now about 35% overvalued.
As shown in Professor Shiller's chart below, the average CAPE for the past 130 years or so has been about 16X. Now, with the S&P 500 at 1200, it's about 22X. This suggests the S&P 500 is about 35% overvalued.
click top enlarge
Blue line = cyclically adjusted PE; Red line = interest rates
Image: Robert Shiller
Now, before you go shouting that stocks have been overvalued for much of the past two decades and that over-valuation hasn't made them go down--you're right.
But what valuation does do--and more reliably with this indicator than many others--is give you a relatively reliable sense of what returns you can expect over the long term. And from this level, the returns you should expect are decidedly below average.
Fund manager John Hussman and others think the current level of overvaluation, combined with everyone's relative bullishness and the extreme level of corporate profit margins, means that the day of reckoning is coming sooner rather than later.
Others, the bulls, think Ben Bernanke's desperate attempts to fix the economy and get his president re-elected will result in stocks soaring higher from here (the "third year in the presidential cycle" effect that Jeremy Grantham and others have documented).
Well, over the short term, we have no idea who is right.
But we have a lot of confidence in Professor Shiller's PE ratio as a long-term return predictor. So we're not looking for stocks to appreciate more than 5% a year for the next decade from this level. And we certainly wouldn't be surprised to see a breathtaking correction.
(Oh, and please don't argue that high PEs are justified because of today's low interest rates. For two reasons, that argument is bogus. First, as you can see in the chart above, the reverse correlation between PEs and interest rates is a relatively near-term phenomenon. In the 1930s, interest rates were very low and so were PEs. Second, the goal of any valuation tool is to tell you what stocks are likely to do in the future, not where they are today. So unless you know where interest rates are going tomorrow, they won't tell you much about where stocks are headed.)
Disclosure: No positions