Investors today have good reason to worry about stocks.
Europe, the U.S. and emerging markets are facing real problems
today and economic recoveries after financial crises
almost always take longer than recoveries after ordinary
downturns. The global economy may take several more years to
fully recover from the credit crunch, and so may the stock
market. Both could weaken again before getting better.
Indeed, our research has found that after 15 systemic
banking crises around the world, the stock market took nine
years on average to regain its prior peak. We dont know
if the recovery from the recent crisis will take a longer or
shorter time than average, but assuming it is average,
were now about halfway through.
But even taking these risks into account, we dont
agree with those who argue that the stock market is overvalued.
To begin with, it doesnt make sense to say the market is
expensive, given where bond yields are today. The display below
shows the remarkably close relationship between the S&P
500s price-to-earnings (P/E) multiple and the 10-year
U.S. Treasury yield since 1970. (The curved trend line shows
the average P/E for a given level of interest rates.) In
general, stock market valuations have been high when interest
rates were low, and low when interest rates were high, for good
Low bond yields tend to reduce companies borrowing
costs. They also drive up the present value of future earnings
and dividends, and they make bonds a less appealing alternative
to stocks. High bond yields, by contrast, drive up
companies borrowing costs, reduce the present value of
their future earnings and dividends, and make bonds more
appealing relative to stocks.
Since the beginning of 2008, 10-year Treasury yields have
been below 4 percent, and the market P/E has been far below the
trend line almost all the time, as shown by the light green
squares in the display. The few light green squares above the
trend line are for very late 2008 and 2009, when earnings fell
to very low levels.
In June 2012, the 10-year Treasury yield was below 1.5
percent and the S&P 500s P/E was 12.5, far below and
to the left of the trend line. Its the green dot in the
display, the extreme outlier. To fit on the trend line, the
S&P 500s P/E would today have to quadruple, to about
50. While we certainly dont think the market should be
trading at 50 times earnings, todays low bond yields
suggest that the market should be trading at or above 17.6
times earnings, its average multiple since 1970.