Monday, March 1, 2010


I found a great website by Robert Schiller the Yale professor. He's provided interesting details going back to 1875 of market levels including interest rates, index prices, and P/E ratios. I have used his data to give us a picture of the S&P 500 index charted against the long term P/E ratios for the market.

The chart is useful because we can see that the rebound in the markets over the last 10 months has now propelled us into levels that indicate that the market is overvalued. Two things can happen to adjust this imbalance. First, earnings can improve, this will decrease the denominator of the equation and bring the calculation into equilibrium. The second is that stock prices can fall back in line with earnings to balance it out. Recall that the long term median P/E for the market is 15, so we are 30% above the average.

If you look at 2000 and 2007 you should see that just because we have spikes above 20 doesn't mean that the market will immediately collapse, but it is an indication that a stocks are over-valued and will regress toward the mean. It doesn't escape me that the last 15 years has been spent at P/E's greater than the norm. I also think we would agree that the last 15 years has been a period build on excessive debt and the illusion consumers could leverage themselves to happiness. Remember, consumers have been borrowing to buy stuff they didn't need thus creating demand that supported entire industries.