Stock prices are at a very high level, and yet investors have not pulled back. A new blog by University of Hawaiʻi Economic Research Organization (UHERO) Senior Research Fellow Byron Gangnes describes why evaluating the future paths of stocks is difficult, but provides one indicator of current stock market values that could signal their pending future.
A commonly reported measure of stock value is the price/earnings (PE) ratio, which for the S&P 500 stock index was above 26 on July 19, much higher than its average of roughly 16 since 1872.
A major challenge is to know what measure to use as an estimate of expected future earnings. The PE ratio uses the latest reported earnings, which may be affected by a number of factors, including the stage of the business cycle. One partial solution is to use average earnings for a much longer historical period. Robert Shiller introduced the idea of a cyclically adjusted price/earnings ratio (CAPE) that uses average inflation-adjusted earnings from the previous 10 years.
On July 19, the S&P 500 CAPE stood at nearly 32. While not as high as it was prior to the COVID-19 pandemic, it suggests stocks are higher relative to earnings than they have been in nearly every year since 1872—even higher than they were before the Black Tuesday stock market crash of 1929. A very high PE ratio implies very low earnings per share. When interest rates were rock-bottom low, stock earnings looked very attractive. But now safe U.S. government bonds are paying a lot more than before. On July 19, the one-year fixed maturity U.S. Treasury bill was paying 5.3%, compared with an earnings yield of just 3.8% on the S&P 500. This makes it even harder to understand why an investor would prefer risky stock investments at this time.
Aggregate PE measures suggest that overall stock prices at least for the S&P 500 may be overvalued or very overvalued by historical standards. However, these prices may nevertheless be reasonable, according to Gangnes. One possibility is that the average earnings for the previous 10 years are a poor proxy for expected earnings now. For example, stock prices often begin to turn up before a recession or a period of slow growth has ended, because of optimism that the economic (and therefore revenue) outlook has improved, justifying a higher stock price.
AI boost for some companies
In addition, there may be unusual factors at work that justify a high earnings outlook. For example, the recent emergence of generative artificial intelligence (AI) may create expectations of significant value growth for related companies. Goldman Sachs has estimated that AI could boost productivity by as much as 1.5 percentage points annually over the next 10 years, raising S&P 500 profits by 30%.
Moreover, five tech companies (Apple, Microsoft, Alphabet, Amazon and Nvidia) have accounted for most of the stock index appreciation this year. Of course, the dot-com bubble of the late 1990s reminds us that investors can get excessively optimistic about how much technological progress will boost company prospects. The tech-heavy NASDAQ soared about 800% between 1995 and 2000, only to give up virtually all those gains by 2002. Gangnes said he thinks it is fair to say that no one knows how much of the current AI hype will turn out to be justified in the long run.
PE ratios provide one signal about current stock market values. Right now, that signal is flashing bright red.
—Byron Gangnes
“There are other reasons that individual investors might stay invested in stocks despite their current high prices relative to earnings,” Gangnes said. “Since bond prices tend to be inversely related to interest rates, bonds could face capital losses if there are further interest rate hikes. Many investors are in it for the long haul and will tolerate stock market declines in order to take advantage of potential gains. And, of course, these PE ratios are averages across many stocks, so even with high overall valuations, specific stocks will still be attractive.”
Gangnes concluded, “Evaluating stock prices and especially their future paths is extraordinarily difficult. But PE ratios provide one signal about current stock market values. Right now, that signal is flashing bright red.”
See the entire blog on UHERO’s website.
UHERO is housed in UH Mānoa’s College of Social Sciences.
