Are Stock Valuations Too High?

US stocks have continued to climb this year even after surging by more than 30% in 2013. Earlier this year we argued that US stocks appeared to be slightly overvalued, but other analysts argue that stocks are fairly valued. Which analysis is correct?

To answer that question it’s important to remember the basics of how valuations apply for long-term investors. When valuations for a specific asset class are above their long-term average, we can expect the future medium-term returns for that asset class to be below their average. The opposite is true when valuations are below their long-term average.

In their latest quarterly outlook, analysts at JP Morgan have presented the following charts seeming to show that US stocks are fairly valued:

Stock Valuation Charts

The problem with this analysis is that their “long-term average” is based on 25 years of data, a brief interval in the long history of financial markets. The average value for the Shiller P-E ratio, for example, has been 25.1 over the past 25 years, only slightly below the current value. But its true long-term average (using data since the 1880’s) has been only 16.5, suggesting that current valuations are higher than normal.

Of course, valuations don’t tend to have much of an impact in the short-term (technology stocks continued climbing in the late 1990’s long after valuations reached extreme levels, for example). And US stocks today appear to be only slightly overvalued, unlike the extreme overvaluation of, say, technology stocks in the late 1990’s or Japanese stocks in the late 1980’s). So while valuations suggest that the future returns for US stocks may be slightly lower than they otherwise would be, they don’t preclude the possibility of the current bull market continuing for a while.