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This indicator screams stocks are overvalued

Yahoo Finance’s Brian Sozzi shares what the Shiller P/E Ratio is and breaks down how its impacting the stock market.

Video Transcript

MYLES UDLAND: All right, welcome back to Yahoo Finance Live on this Wednesday morning. Brian Sozzi's got my number this morning, trying to talk about an indicator that says the market is overvalued. Lay out the case, Sozzi. Tell them what I need to know about this one.

BRIAN SOZZI: Well, I specifically chose this one for you, Myles, because I knew you are a big fan of valuation measures and indicators that suggest that stocks might absolutely fall off a cliff. So my measure today is the famed-- famed-- Shiller PE ratio. I know you love this one. I know it has a lot of fans out there in the world of investing.

So what the heck is the Shiller PE ratio? Three things to really break it down. It adjusts annual S&P 500 earnings by inflation. It uses a 10-year average of earnings as the divisor, and it uses the S&P 500 index as the numerator. In plain, actual English, it's seen as a true-- truer valuation measure. It kind of smooths earnings out. At least, that's how I've been taught to read it.

Now, what is this measure saying right now? Again, this is your favorite, Myles, the Shiller PE ratio. What is this saying right now? The current ratio for it here, it now stands at 38 times. That is inching closer to the 44 times level seen at the peak of the dotcom, I would say, crisis back in 2000. Now, historically-- and I'm using a lot of this data that comes from Sundial Capital Research that tracks a whole lot of good historical data on markets.

Historically, readings over 20 for the Shiller PE ratio just haven't been good for stocks. You have seen when it has broken above 20, and specifically, even 30, the market has gone on to decline. And you see that fancy chart here, put together by the awesome Yahoo Finance team. You can see that when it goes above these-- above that 20 level, definitely above 30, I mean, the market historically could-- it has fallen off a cliff. This has happened before. This has happened over time when this ratio breaks that level. It's just how it goes.

Now my hot take is very simple here, Myles. Then I will yield the floor to you. I know you're very excited about this one. My hot take is this. Valuations on individual stocks and the broader stock market still matter. They still matter, even if the Federal Reserve's actions have made using proper valuation techniques borderline useless. Myles.

MYLES UDLAND: Well, I mean, there's so many problems with the language in the proper valuation measure. I mean, valuation is a function of what the risk-free rate is, and also what corporate earnings are, and thus what one could earn in assets other than equities. So you can't just say it's improper because interest rates happen to be low. Also, this whole 20 business, I mean--

BRIAN SOZZI: Look at that chart, Myles. Hold on, look at it. Look how beautiful that is--

MYLES UDLAND: Hold on, hold on.

BRIAN SOZZI: --the Shiller PE ratio.

MYLES UDLAND: On the multiple-- so MULTPL. So no-- we've got no-- what am I looking for? Vowels in there. Multiple.com, where they have all this data for you, you can do it by table, which gives you the Jan 1 valuation measure on a Shiller PE ratio over-- basically, what am I looking back? It goes back to 1872 here, right? So I'm looking at the years in which the Shiller PE is 20 or higher at the beginning of the year. And you're trying to tell me that this is bad for stocks?

We're talking about years like 1992, 1994, 5, 6, 7, 8, 9. So you're telling me those are bad years for the stock market. Now I'm also hearing that 2003, '04, '05, '06, and '07, those were apparently bad years for the stock market, as are 2010, '11, '12, '13, '14, '15, '16, '17, '18, '19, 2020 apparently a bad year for the stock market. I guess 2021 has been a bad year for the stock market. It just-- it doesn't add up. Like, valuations are in the context of what the risk-free rate is.

It's also in the context of what the earnings profile for businesses happens to be, just because in the 1960s, you could go by the market at, what, 17 times here. Even in the '60s, by the way, the Shiller PE was over 20. In the '70s, you had 8. 1970-- what, we want 1975's market? That's the only time stocks were a good buy? Get out of here. Nonsense.

BRIAN SOZZI: Well, I have two things to add here. First, Myles, I am going to send you Robert Schiller's email address, because he's the one that created this, and I didn't create this market data. Number two, I know--

MYLES UDLAND: I know what he's saying.

BRIAN SOZZI: I know you just want to get done with this conversation. You're ready for the jobs report. You're excited about the jobs market special that we have on Yahoo Finance on Friday. Very excited. So you just want to keep it moving.