Taking Stock Market at Face Value

On a simple price/earnings multiple, stocks look cheap. But things aren't so simple.

The S&P 500 now trades at 15.5 times the past year's earnings, under generally accepted accounting principles. That compares to an average price/earnings multiple of 17.8 since 1950. By that metric, the stock market is about 15% below where it should be. Load up your boots.

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Many stock-market cognoscenti are disdainful of comparing stock prices to the past year's earnings, however. Profits are highly cyclical: If earnings turn out to be at their peak, stocks can have low P/Es and be overvalued. So taking cues from Yale economist Robert Shiller (who took his from Benjamin Graham and David Dodd), they compare prices to earnings over the past 10 years. Do that, and stocks don't look cheap at all.

The S&P 500 trades at 22.3 times the past decade's average, inflation-adjusted annual earnings. That compares to an average level of 18.7 since 1950. So stocks are 19% higher than they should be. Sell.

But while comparing stocks to their past 10 years' earnings might normally be a fine idea, at the moment it is a bit problematic. The earnings collapse that followed the 2008 financial crisis was the worst in U.S. history. The earnings collapse in the early 2000s following the bursting of the dot-com bubble also affects the numbers. When it happened, it was the worst since the 1930s.

Both earnings collapses were consequences not just of downshifts in the economy but large write-offs associated with the accounting scandals that followed the dot-com bust and the mountain of debt that went bad after the housing bust. They may have had less to with the underlying profitability of companies in the S&P 500 than with those companies' past excesses.