Are Stocks Expensive?

by: Investment Pancake


The earnings premium on the S&P 500 compared to interest rates on a US Treasury suggests that stocks aren't expensive.

Tracking the average earnings premium on the S&P 500 for the past 150 years shows a huge secular shift that started in 1950 and lasted until 2000.

The total five-year and ten-year returns on the S&P 500 seem to have disconnected from the valuation of stocks from 1975 until 2000.

It seems like an age-old question: Is the stock market overvalued? Isn't it true that you should be hoarding cash.... whilst chewing your nails with acute sensations of financial panic?

I can't answer that question for you, but consider the following.

Investors have two basic choices: own low-risk assets (like a US Treasury) and collect a fairly certain return (like interest payments), or own higher risk assets (like stocks) and collect a fairly uncertain return (like a share of corporate earnings). All things considered, most investors prefer a certain return to an uncertain one, unless that uncertain return could be much higher than the certain one. This difference between the low-risk return and high-risk return is called a "risk premium."

The return on a stock investment equals the company's earnings per share, divided by the price of the stock. For example, if a company earns $1 per share and the stock price is $10, the earnings yield is 10%. Most of the time, the earnings yield on stocks trades at a premium to the interest rate on a US Treasury because earnings fluctuate (making stocks a riskier bet). You could say that the lower this premium is the more expensive the stock is compared to its next best alternative (which is the low-risk US Treasury).

Since earnings move around a lot over time, it's nice to average the last few years of earnings so you get a more stable, consistent picture. You can take these average earnings and use them as the basis for figuring out a stock's earnings yield. And, you can do that for the entire S&P 500 if you want to. I did. I took the average ten year's worth of earnings for the S&P 500 since 1881 (which I pulled off of Professor Robert Shiller's homepage) and used that to figure out the earnings yield on the S&P 500 for each month from 1881 to the present. I then divided each earnings yield by the then-prevailing interest rate on a ten-year US Treasury, to see what the earnings risk premium has been for the last century and a half.

Since the risk premiums bounce around wildly, I decided to smooth the data out by taking a rolling average for monthly risk premiums, spreading each data point over a one-year period.

Finally, I decided to weight the data, so that more recent data are given more weight and more remote data are given less weight. To do that, I simply multiplied the moving average by a date fraction so that today, that fraction would be 1, and April of 1881 would equal .933. Etceteras.

And, here is the result. It is a graph that tracks the average earnings premium on the S&P 500 since 1881, compared to prevailing interest rates, and giving more recent data slightly more weight in the analysis.

What does this chart suggest?

First of all, something dramatic changed in 1950. From 1950 on, stocks suddenly became wildly more expensive than they'd ever been at any time in the past OTHER than the late 1920s. Stocks went from historically cheap in 1950, exploded higher in price until the 1970s, and then more or less got consistently more and more expensive until 2000. From 2000 on, stocks appear to have gotten steadily cheaper. Does anyone have any guesses about why this might have happened?

Second, the most expensive stocks have ever been was 2000 (at least by my measure). The second most expensive time was in the early 1970s, and the third most expensive time was 1929.

Third, stocks today are priced at around where they were priced in the early 1960s or 1900s. In terms of valuation, we're in the best spot we've been since the mid-1960s (according to the methodology used in this article).

And, last of all, here is the same chart, except for each date, I added the total return investors made over the following five-year period (total dividends plus any capital gains, shown in the red line). Unsurprisingly, stocks had much higher returns in periods when shares were cheap, and negative returns when shares were expensive... but not always. Look at the 1980s and 1990s - these epochs produced very strong five-year returns even though stocks were pretty expensive by historical standards. Valuation doesn't seem to have had a lot of short-term predictive power over the last 45 years (at least, not the way valuation was calculated for purposes of this study).

Even when you look out of the next TEN YEARS of subsequent returns, the relationship between cheapness and returns remains fairly tight until about 1975. What happened????? It's like everyone got freaky for 25 years. I blame disco and bell-bottoms, but hair mousse and neon fishnet stockings obviously played some role as well. Fortunately, with the passing of the hair mousse and neon fishnets, it seems that we all appear to have started to return to our collective senses in 2000. Or at least it does if you define rationality as meaning "price equals value as measured in this article". Most of us who were involved in the market back in 2000 would say that the reason for this jarring removal of the punch bowl in 2000 seems to have everything to do with the collapse of the internet bubble. But the chart suggests something was going on with stock prices for a couple of decades before the internet was even created.

I'd be very curious to hear anyone's perspective on the strange burst in stock prices we saw starting in the 1950s, the bizarre disconnect between value and subsequent returns throughout the 1970s, and the sudden removal of the collective punch bowl in 2000.

A link to the spreadsheet for those who want to see it is here:

Are stocks expensive today?

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.