Tuesday, May 20, 2008

More On The Sucker Rally

Daniel Halvarsson has an interesting post where argues that the U.S. stock market is currently overbought from a technical point of view. There is certainly no doubt that the market is overvalued from a fundamental point of view. Stock prices are only slightly lower than year ago levels, even as earnings have plummeted some 26%.

Bulls of course usually respond to this by saying that if you exclude financial companies and consumer discretionals, then earnings are in fact up. But comparing earnings excluding financials and consumer discretionary companies with the market movements including these companies is a blatant case of comparing apples and pears. Since these stocks have fallen the most (Citigroup is for example down more than 50%) and the market too is up quite a bit excluding them and since stocks were very expensive to begin with, then the fact remains that stocks are very expensive.

Via Greg Mankiw I see this illustration of that point, with a chart comparing stock prices to a 10-year moving average of actual earnings. Although as you can see valuations are well below the peaks of the tech stock bubble and has recently slightly improved (unlike the p/e ratio for the most recent year's earning which has soared), valuation levels remain well above the levels seen before the tech stock bubble.

UPDATE: Daniel Halvarsson has noticed my post and posted an even better graph over how the use of 10-year moving averages in earnings indicate that U.S. stocks are generally overvalued.


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