May 4, 2017


No, an Above-Average P/E Ratio Does Not Show Stocks Are Overpriced (ALAN REYNOLDS, 5/02/17, Cato)

[T]here is no reason to expect the p/e ratio to revert to its long-term average unless bonds yields revert to their long-term average.

The graph illustrates this connection by inverting the trailing S&P 500 price/earnings ratio and expressing it as an earnings/price ratio. This became known as "The Fed Model," though I prefer to call it "The Reynolds Model," because I first used it in March 1991 (to suggest bonds, rather than stocks, were overpriced). From 1970 to 2016, the average e/p ratio was 6.52 (equivalent to a p/e ratio of 15.2) while the average yield on 10-year bond yield was almost identical at 6.57%. That connection between stocks and bonds has been quite close over the long haul (though not before August 1971 when the dollar was convertible into gold).

An oversimplified thumb rule from Investopia says, "If the earnings yield is less than the rate of the 10-year Treasury yield, stocks as a whole may be considered overvalued." In 2016, the earnings yield of 4.17 was about twice as high as the 10-year Treasury yield of 1.84, which suggests the earnings/price ratio was then too high and therefore the price/earnings ratio (or bond yield) was too low. 

On May 1, 2017, the p/e ratio was 25.26, which is equivalent to an e/p ratio of 3.96 (=1/25.26). Since an earnings yield of 3.96 is obviously much higher than recent bond yields of 2.3%, the market is still "undervalued"-not "fragile."

Posted by at May 4, 2017 6:23 PM