Are Stocks Overvalued?

Money Magazine puts out an annual "Professional User's Guide."  This year they have a "best of" section, and one of the items (p. 78)  is "Best New Way to ...Tell If Stocks are Overvalued."  It is based on Robert Shiller's (recent Nobel Prize Economics recipient) work on average inflation adjusted price-earnings ratios (CAPE ratio) and subsequent stock market returns.  Shiller uses the 10-year average of past earnings.

The Leuthold Group has done further research and found better predictions come from using 5 years of past average adjusted P/E data.

They found that, if 5-year adjusted P/Es start at below 10, then 10-year annualized returns average 11.9%.  If P/E is in 10 to 14.9, average return over 10 years is 9.8%, 15 -19.9 gives 6%, 20.0 to 24.9 gives 3.3%, and 25 and higher produces -0.6%.

At the time of the article, the Shiller 5-year P/E stood at 21.3.  Thus, if historical data holds, we can expect 3.3% annualized over the next 10 years.  Not good, right?

Obviously it is not great; but still, in a world where money market rates are practically zero, the 10-year Treasury yield is approximately 2.80%, and most inflation numbers are less than 2%, a 3.3% annualized return is not something to necessarily thumb our noses at.  Throw in the fact that most Central Banks are like deer caught in the headlights when they contemplate the possibility of deflation.

If you accept the Leuthold Group findings of 3.3% annualized returns, you may, however, want to revisit your financial plan and revise some numbers.  Most plans predictive of retirement nest eggs are based on anticipated stock market returns of 8 - 10%.

Disclosure: T his post is for educational purposes only.  Investors should do their own research or consult an investment professional before making investment decisions.