Have you seen those cartoon thermometers that swell red-hot and blow up? Thatâ€™s what I see when I look at most stock valuation measures today.
Forward P/E ratioâ€”by far the most popular gauge that looks at stocksâ€™ expected earnings relative to their priceâ€”says stocks are selling at the loftiest prices since the dot-com bubble.
Shiller P/E (CAPE)â€”a cyclically-adjusted â€œupgradeâ€ to P/Eâ€” goes even further. The ratio signals stocks have been more expensive only once in history:
Other measures that weigh up stock prices against business metricsâ€”including EV/EBITDA, P/S, EV/Sales, EV/FCFâ€”all are pointing to an insanely overvalued stock market.
But what if we looked at this upside down? In fact, thatâ€™s the exercise Nobel-winning economist Robert Shiller suggests to make sense of todayâ€™s stock prices.
I know it sounds confusing, and Iâ€™ll explain everything to you in a moment. But first, letâ€™s talk about P/E.
What is P/E and what it shows when you flip it upside down
MORE FOR YOU
What does P/E tell us, exactly?
For one, it shows us how much we pay for a dollar in the companyâ€™s earnings. Or assuming we keep shares forever, P/E could tell us how many years the company has to keep up its current earnings to pay back the price of its share.
The higher the ratio, the more years it takes to recoup your investment.
(Obviously, it doesn’t mean these earnings end up straight in your checking account. But one way or another, they trickle down to shareholders through dividends, buybacks, or reinvestments in the business you own a piece of.)
Now, if you flip P/E upside down, youâ€™ll get a little less-known metric called earnings yield. Itâ€™s calculated by dividing earnings per share (EPS) by market price per share. And in theory, it shows how much you earn on each dollar invested in the stock.
Think of it as the interest on bonds, just not fixed.
The â€œinterestâ€ you earn on the companyâ€™s earnings depends on P/E. The higher the ratio, the more you pay for a slice of earnings. And in turn, you earn less. Conversely, the lower the P/E, the bigger slice of earnings a dollar can buyâ€”which translates to a higher earnings yield.
No surprise, now that stocks are trading at one of the highest P/Es in history, the S&Pâ€™s earnings yields hit rock bottom:
In other words, a dollar invested in the S&P earns the least in years. So why on earth are such unprofitable stocks supposed to be â€œcheapâ€?
Expensive stocks vs. bullcrap-yielding bonds
As you probably know, there are two main asset classes that fight for a place in each investorâ€™s portfolio: stocks and bonds.
As a rule, bonds are a safer investment that give you a steady income with a relatively low risk of losing the invested money (aka principal). The problem is, high-grade bonds pay out little and do not always protect from inflation.
Stocks can earn you more, but at a risk. Their income is not guaranteed, and stock prices can be very unstable. Thatâ€™s why investors ask for a higher return from stocks as compensation for taking that risk.
This extra return they get for buying stocks over the safest bondsâ€”say, 10 year Treasuriesâ€”is called equity risk premium.
Now look what happened to equity risk premium during Covid.
After Covid swept the world, the Fed slashed the rates to near zero, which in turn pushed down bond yields. For example, the real yield (adjusted for inflation) on the worldâ€™s most popular bond, 10-year Treasuriesâ€”fell below zero.
In other words, lower rates made bonds less attractive against stocks. But soon after, stock prices roared past record highs, and their earnings yield fell to rock-bottom lows, too.
So where does this leave us today?
To answer that, letâ€™s look at the recently introduced â€œexcess CAPE yieldâ€ (ECY) for the S&P 500. Itâ€™s the S&Pâ€™s average earnings yield over the past 10 years minus the real yield (adjusted for inflation) on 10-year Treasuries.
In human language, it shows you the premium you earn by investing a dollar in stocks vs. supposedly risk-free bonds. Hereâ€™s what that measure looks like today:
By this measure, the S&P is the most attractive against bonds since 2014. Nobel-prize winning economist Robert Shillerâ€”who came up with the CAPE ratioâ€”wrote in a recent paper:
â€œWith rates so low, the excess CAPE yield across all regions is almost at all-time highs, indicating that relative to bonds, equities appear highly attractive,â€
And that could explain why investors donâ€™t shy away from stocks even at record valuations. There are simply no alternatives.
Stocks are even more attractive overseas
Shiller and his team then looked back 40 years across the world and found even more striking results. The only other time excess CAPE yield was this high globally was in the early 1980s. In other words, this study shows global stocks are the most attractive against bonds in 40 years.
He also added that stocks in Europe, the UK, and Japan are in particular a â€œcatchâ€: â€œThe ECY is close to its highs across all regions and is at all-time highs for both the UK and Japan. The ECY for the UK is almost 10%, and around 6% for Europe and Japan.â€œ
This is one of the most compelling bullish arguments to stay invested in stocks as long as the rates stay near zero. Though, as Shiller and his team suggested, you may want to spread your eggs a bit farther.
On the other hand, itâ€™s quite alarming to see how much investors are banking on central bank intervention. You donâ€™t want to hear them even murmuring about the slightest chance of backing down.
Stay ahead of market trends withÂ Wall Street-grade insights
Every week, I put out a story that explains whatâ€™s driving the markets.Â Subscribe hereÂ to get my analysis and stock picks in your inbox.