The ACM Journal 2013 Q4

Are Stocks Overvalued and Ready to Correct?

We have fielded a lot of questions lately about the level of the stock market. Typically, investors get nervous when the stock market declines in value. However, with visions of 2008 still in our heads, many investors are increasingly nervous as stocks continue to rise and reach new highs. Accordingly, we thought we would take a closer look at valuation levels.

Robert Shiller, a finance professor at Yale University, and a recent Nobel Prize recipient believes that stocks are wildly overvalued. As evidence, he cites the “Cyclically Adjusted Price/Earnings Ratio”, which he developed. This ratio is an indicator that shows the value (the price or “P” in “P/E”) of stocks today versus their historical earnings (the “E” in “P/E”) smoothed over the past ten years. This metric shows that stocks are trading at a Cyclically Adjusted P/E Ratio of around 25 times their historical earnings. The average since 1871 (that is not a typo, the data actually goes back to when Ulysses S. Grant was president) was 16.5. The current reading is obviously quite high by historical standards. This is all the more alarming because Robert Shiller correctly called both the internet and housing crises.

Even scarier, respected research firm The Leuthold Group notes that current valuation levels are identical to those of the bull market highs of 2000 and 2007, just before things got really ugly. However, in order to have a free market, both sides of a debate must be represented. If everyone thought the market was going to go in the tank, it would already be there. There is just as much heft on the other side of the argument.

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