How expensive is the stock market?
An analysis on why currently stock prices are as high as they are.
There is no denying that stock market prices are historically very high right now. The S&P 500 is at an all-time high and had an approximate growth of 33% last year. This is more than three times the growth rate of previous years.
Despite the high prices that the stock market faces at the moment. However, the question must be asked whether the market’s prices are not only expensive but overpriced.
To determine that, the price has to be compared to the performance. A combination of high prices and high performances sum up to a reasonable value. However, a stock that is very expensive while performing poorly is rather overpriced.
A good measure of price versus performance for the US market is a metric called the Shiller PE.
It compares the price of the S&P 500 to the average, inflation-adjusted earnings of the index over the past ten years.
On average, this metric is 16.84, which means that investors are in general willing to pay 16.84 times the average earnings of the past ten years as a share price. Currently, the Shiller PE is around 38, showing a dramatically high increase in the last several years.
S&P 500 Shiller CAPE Ratio, https://ycharts.com/indicators/cyclically_adjusted_pe_ratio
A high Shiller PE mostly results from two reasons: either the average earnings of the past ten years have been very poor, or the prices have risen very highly. The current status of the stock market indicates that both of those reasons were triggered.
When analyzing the average earnings of the S&P 500 in the past ten years, the impact of the pandemic can be observed very clearly. Due to the COVID-19 situation, the growth over the past 10 years has been just 2.4 percent.
Earnings of the S&P 500 in past 10 years, https://www.multpl.com/s-p-500-earnings/table/by-year
Nevertheless, as already suggested, the poor earnings of the index are not the only reasons for the high Shiller PE. Even if the metric is calculated with the earnings before the pandemic started. It still would be 33.5, which is twice the Shiller PE’s mean. This means that the index is not only performing poorly but that the prices are extremely high too, as already observed.
But why are the prices rising constantly despite the relatively low earnings?
Among other reasons, this has to do with the relationship between stocks and bonds.
While private investors tend to be patient and non-active in times of market peaks, large hedge funds or other organizations that manage large amounts of money try to always stay invested. Given that, the selection of where to put the money mostly consists of stocks and bonds.
Considering that interest rates have been very low for some time now, the stock market seems much more promising than bonds, resulting in more money going into the stock market despite high prices. The Shiller PE of the S&P 500 is more than suboptimal, however, still holds more potential than bonds.
How is this expected to continue in the future?
Given the amount of dollars printed in the last 18n months, inflation will most likely grow. Since the Federal Reserve controls inflation with interest rates, an upcoming rise in interest rates is very realistic.
If we look at the relationship between stocks and bonds again, we would expect to see more money flowing in the direction of bonds than stocks eventually, causing a decrease in the price of the stock market, which could result in a more balanced price/earnings metric and a less overpriced market.