NCPA - National Center for Policy Analysis

Are Stocks Overvalued?

April 5, 1999

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.

Economists point to various reasons for thinking there will -- or won't -- be a major correction. For instance:

  • The ratio of earnings to stock prices last year was at the unprecedentedly low level of 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.
  • Comparing the earnings yield on the Treasury's 10-year bonds, which have been about 5.16 percent lately, to the earnings yield on the Standard and Poor's 500 companies, which has been 4.17 percent, suggests stocks are 24 percent overvalued.
  • However, Arthur Laffer points out that the S&P 500 stock index is very closely aligned with capitalized corporate profits, and 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, 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.)

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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