Some Comments on Current Valuations

Given the recent turmoil in the markets, and the corresponding cries from pundits that stocks are still expensive, I thought it would be appropriate to examine some of the numbers to see how stocks and bonds are currently valued relative to inflation and recent history.

First of all, here are where things stand now:

Inflation, as measured by CPI:  .5% (though core inflation is higher @ 2%)

CAPE or Shiller P/E:  24.34

Trailing 12 month P/E (S&P 500):  ~20

S&P 500 earnings yield:  4.94% (estimated)

10 year Treasury bond yield:  2.09%

S&P 500 earnings yield – 10 year Treasury bond yield:  2.85%

Since 1950 (an arbitrary starting point since I feel the data since then are both more reliable and more relevant), these are the averages:

Inflation, as measured by CPI:  3.51%

CAPE or Shiller P/E:  19.09

Trailing 12 month P/E (S&P 500):  17.63

S&P 500 Earnings Yield:  6.79

10 year Treasury bond yield:  5.7%

S&P 500 Earnings Yield – 10 year Treasury yield:  1.09%

Clearly, inflation is much lower than its historical average, though that’s likely a temporary phenomenon.  Both the CAPE and trailing 12 month P/E levels seem elevated relative to the 65 year average.  The earnings yield has come down, but so, too, have Treasury bond rates, meaning that the spread between the two is considerably higher now than the average.

However, looking at averages doesn’t tell the whole story.  Inflation, in my opinion, is a critical component in the analysis, because it drives our expectations for future real returns.  Therefore, I think it makes sense to compare how the results looked when you accounted for inflation.  I used 3% instead of the average of 3.51% because it gave both samples a more or less even size, and the results wouldn’t be changed all that much.  Here’s what I found:

Given today’s low inflation rate, current valuations don’t seem very excessive, and the CAPE/Shiller P/E is modestly higher than the post 1950 average.

The current yield on Treasury bonds remains well below its average even when accounting for low inflation.  A possible explanation for this is the current strength of the US dollar, which, along with a yield that, – while low by our standards, – is positively rich by current developed nation yields, makes it an attractive investment foreigners looking for a safe haven.

Obviously, this is not meant to suggest that stocks are cheap, or that you should sell your Treasury bonds.  It’s simply meant to add some perspective to the valuation conversation, and to help you as an investor view valuations in the proper context.