Wednesday, December 02, 2009

Stocks Are Overvalued

David Leonhardt points out that stocks are overvalued from a fundamental point of view, with the Graham P/E (stock prices relative to the 10 year moving average of earnings) being well above the historical average. Using a 10-year moving average has the drawback of being very backward looking, but this is in my view more than compensated by the fact that it removes short-term cyclical fluctuations in earnings and focuses on long-term profitability.

Since we have now been in a cyclical downturn, the traditional P/E comparing the stock price just to the latest year's earnings makes stocks look even more overvalued.

On the other hand, interest rates are relatively low now. But since that is largely a result of weak growth prospects, that may not justify high stock prices. An example of this is the case of Japan. Japan has had long term bond yields of 1 to 2% for more than a decade, yet stock prices there have kept falling because of weak Japanese growth.