Opinion Editorial | |
| Monday, April 5, 1999 | |
Are Stocks Overvalued? |
As stocks have risen to historic highs, more and more economists are predicting imminent doom. "This is a speculative bubble," says Ronald Taley of WEFA, an economic forecasting firm. Other economists are less colorful in their warnings, but they point to the fact that the ratio of earnings to stock prices is at an unprecedentedly low level. Last year the ratio was 3.46, less than half the long-term average. Historically, when the ratio is this far from the long-term average it leads to a major correction.
Another approach is to compare the earnings yield on stocks to equivalent bonds. The Federal Reserve favors this approach. Lately, yields on the Treasury's 10-year bond have been about 5.16 percent, while the earnings yield on the Standard and Poor's 500 companies has been 4.17 percent. This suggests that stocks are 24 percent overvalued.
Other economists, however, are less concerned about price/earnings ratios. Arthur Laffer, for example, points out that the S&P 500 stock index is very closely aligned with capitalized corporate profits (see figure). On this basis, stocks do not appear over-valued given current data for aggregate corporate profits and the level of interest rates.
(Corporate profits are capitalized by dividing them by the 10-year Treasury bond rate. In the 3rd quarter of 1998, the latest period for which the Department of Commerce has published corporate profit data, profits were $826 billion and the Treasury bond rate was 5.46 percent, yielding capitalized profits of $15 trillion. Thus lower interest rates raise capitalized profits and high rates reduce them.)
Of course, such an analysis assumes that the data on corporate profits are accurate. Some economists are suggesting that they may not be. A key problem is that employee compensation, especially for senior executives, now comes more in the form of stock options than wages. But while wages are directly subtracted from profits in the government data, stock options are not. This may cause corporate profits to be overstated by $10 billion or more per year.
Other economists note that government profit figures come primarily from tax returns. But profits as reported in company annual reports may be quite different, since the Securities and Exchange Commission has different rules. Earnings calculated from company reports, therefore, may be higher or lower than those reported in the government's economic accounts.
In any event, it is clear that higher profits and lower interest rates are good for stocks and lower earnings and higher interest rates are bad. This means that as long as economic growth remains steady and inflation stays low there is little reason to expect a stock market crash.
Source: Bruce Bartlett, senior fellow, National Center for Policy Analysis, April 5, 1999.
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