History Suggests Stocks Are 40% Overvalued, Says Professor Shiller

If you watch financial television, you'll hear frequently that "stocks are cheap."

The S&P 500, analyst after analyst will tell you, is trading at about 15 times this year's earnings (and even less on projected earnings), which is just below the long-term average.

So you may think that if you buy stocks today, you are getting a bargain.

But be careful!

Professor Robert Shiller of Yale University, who wrote the book Irrational Exuberance that identified the 1990s stock market bubble, says that the price-earnings ratio that most analysts are looking at is fundamentally flawed. Stocks are far more expensive than they look relative to this year's earnings, professor Shiller says. And, consequently, stocks are priced to return only about 3% a year over the next decade (after adjusting for inflation), versus the usual 7%.

To get a more accurate picture of the market's value, Professor Shiller says, you have to look at earnings over a period of years, rather than focusing on a single year. This is because a single year's worth of earnings is highly dependent on the business cycle: During peak years, profit margins are high, so earnings are temporarily inflated. In trough years, profit margins are low, so earnings are temporarily depressed. If you measure the market's P/E ratio using the temporarily inflated or depressed earnings, you get a skewed picture of the market's value.

Right now, for example, profit margins are near an all-time high. Thus the market's P/E ratio looks lower than it does via Professor Shiller's methodology, which "smooths" earnings over 10 years. The market's P/E using Professor Shiller's methodology is about 22X, considerably higher than the 15X you hear about on TV.

Some analysts argue that Professor Shiller's P/E is outdated. The long-term average P/E of about 15X, they say, has moved higher in recent years--because it's different now. So stocks will trade at much higher levels going forward than they have in the past.

Professor Shiller chuckles at this logic, observing that it's the same logic invoked during most of the great stock market bubbles, including the 1920s and 1990s. The logic was wrong then, he notes. And it will likely be wrong now.

See a 130-year chart of Professor Shiller's P/E here.