Stock Market Overvaluation and the Passive Investor

by: Larry MacDonald

Valuations for stocks look reasonable going by the conventional price-to-earnings (P/E) ratio, but Professor Shiller’s cyclically adjusted P/E ratio says the U.S. market is about 70% overvalued and Smithers & Co.’s q-ratio (market cap/replacement cost, as defined on their website) says it’s 17% overvalued. Here is a chart showing both measures.

Both Prof. Shiller and Smithers & Co. will be the first to say that neither of their valuation yardsticks forecast where stocks are going in the short-term. Indeed, stock markets could climb upwards in 2008 and become more overvalued. However, over the long haul, they believe, stock values should revert to the historical means in their indexes.

The overvalued readings in their measures may have implications for the school of passive indexing, which focuses on the long run. Adherents correctly point out that stocks go up over the long run, so all one has to do is hang on through the volatility. But going by Shiller’s and Smithers & Co.’s indicators, the wait may take longer than it would if the passive investor was starting their indexing in a period when the two valuation indexes were showing undervaluation.