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3 ways of measuring if stocks are overvalued

MoneyWatch 10/5

Despite some big daily ups and downs, the stock market, as measured by the S&P 500 index, is not far off its all-time high of 2,194 hit in August. Still, lots of people are nervous about investing in stocks, and many distrust the financial system. 

And they’ve got plenty to worry about, including the phony account scandal at Wells Fargo (WFC), concerns about how the election might affect the economy and the markets and the rising odds of an interest rate hike from the Federal Reserve before year-end. And the liquidity and capital conditions at Deutsche Bank, the largest bank in Germany, are starting to sound too familiar to the events that led up to the collapse of Lehman Brothers.

By some measures, specifically when you compare stock prices to corporate earnings, equities overall do appear to be expensive. But if that’s your only yardstick for selling out of a stock, you may be missing other important considerations. 

And remember that when you decide to sell an investment, you’re making a decision to buy another. Even if you’re letting the stock sale proceeds sit in cash, you have in essence sold stocks and bought cash. So you should compare how you expect stocks to perform versus cash during your investment holding period.

Here are some of the measures to consider when forming your view of current market valuations.  

Price/earnings ratio: The ratio of the trailing, or “as reported,” earnings for the S&P 500 index stands at about 24.81. A year ago, it was at 20.59. The P/E for estimated earnings, called the forward P/E ratio (because it’s based on forward, or estimated, earnings for the next 12 months), is at about 18.43. The historical average for the forward P/E is 15 to 16. So, by this measure, stock prices would have to fall by about 15 percent to bring this ratio back in line with historical averages.

But consider that during the dot-com boom in 1999, the forward P/E stood at nearly 34 for the S&P 500. So we’re a long way away from that sort of stock bubble.

Dividend yield: This is a measure of a share’s annual dividend divided by the share’s price. Through June, the dividend yield is about 2.02 percent versus about 2.22 percent a year ago. 

When looking at the dividend yield, you should also look at the 10-year U.S. Treasury bond yield because that’s the measure of the so-called risk-free rate of return. Today, the 10-year Treasury is about 1.56 percent, so it’s really not a compelling option to put your long-term money into that now.

Earnings yield: The earnings yield is the inverse of the P/E ratio. It’s the earnings of the S&P 500 index divided by the price of the index. It currently stands at 4.02 percent. A year ago it was 4.99 percent, and back in 2000 it was 3.04 percent. This is a measure of the real earnings per share of the stocks in the S&P 500, and you can think of it as the percentage income you would receive if 100 percent of income from all S&P 500 stocks were distributed to shareholders.

When compared to the 10-year Treasury, the earnings yield is almost 2.6 times the Treasury’s current interest rate. Back in 2000 the earnings yield was less than half of the interest rate on the 10-year U.S. Treasury.   

So what can you take away from all of this? 

There’s no simple, single rule-of-thumb that tells you everything you need to know to make a decision about buying or selling stocks. As in many other areas of life, you’re better off if you can come at the question from several different angles.

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