U.S. Stocks are up by about a quarter since the start of the year with 472 of the 500 stocks in the S&P 500 up since December 31st, 2012. IPOs are getting attention following the successful launch of Twitter. And more commentators and gurus are arguing for further gains, a coming collapse or both. Should we abandon stocks on worries that the bear markets of 2000 and 2007 will return? Or, is it “Damn the torpedoes and full speed ahead” into the stock market?
Two widely-recognized measures of market over- or under-valuation are Robert Shiller’s cyclically adjusted price-earnings ratio, CAPE and Tobin’s Q. CAPE is a version of the usual ratio of stock price to earnings which uses the inflation adjusted price of the S&P 500 index and divides it by inflation-adjusted earnings per share averaged over the last ten years. These adjustments usually yield a higher figure than the simple PE. Currently CAPE is about 24 and the usual calculation of the PE is about 17. The chart, based on data on Shiller’s web site, shows CAPE from 1980 to now. The average since 1980 is 21. The current level is above the average but not as high as at recent market peaks.
Tobin’s Q is the ratio of the market’s value to the replacement cost of the assets of companies in the stock market. It is something of analogy to a price-to-book value ratio. The ratio was developed by James Tobin an economist and Yale professor as part of research on financial markets, monetary policy and the economy. Its current values, like CAPE, are above the long term average but also below historic peaks. The web site http://advisorperspectives.com/dshort/ often provides comments and updates on Tobin’s Q.
Neither CAPE nor Q react quickly enough to time the market or give buy or sell signals. They do indicate if stock valuations are rising or falling and are high or low compared to long range norms. Both indicate that stock valuations are higher today than a year ago and certainly higher than in March 2009 when the market bottomed.
If a portfolio was 60% stocks and 40% bonds at the start of the year, it is now 75%/25% with no trading at all. If an investor was comfortable at 60/40 in January, is he or she comfortable at 75/25?