Just how ‘over the top’ are US stocks?

Do you have a hunch that today’s shares generally feel too pricey?

I’m talking here about valuation. Probably the best and most widely used measure is the price-to-earnings (p/e) ratio. This compares the price of a share with the amount of profit ‘earned’ by that share. The higher the p/e, the more expensive it is.

The p/e of individual stocks can vary quite a lot, as it depends on each company’s prospects and also what’s in fashion at any one time. But across the entire market, valuation levels are much more stable. The individual swings and roundabouts balance out.

Of course, the overall market p/e also varies. This tends to be driven by movements in interest rates. If rates fall, for example, the returns on offer outside the stock market will drop. That makes company earnings and dividends more attractive to investors. So valuations, and share prices, tend to rise. The opposite happens when interest rates go up.

And over the past 15 years, shares have seen a quite extraordinary surge in the value that investors place on them. Just look at the chart below of America’s S&P 500 index (and please bear with me on the jargon front for a second…)

The average ex-bubble mid-cycle p/e (represented by the solid blue line) isn’t quite as complex as it sounds. It’s just the S&P’s long-term average valuation between booms and busts. And the two dotted blue lines on either side show how this valuation could oscillate around the average. A spread of ‘one standard deviation’ means that most of the likely bases are covered – almost 70% of likely outcomes fall within this band.

But you can clearly see what has actually happened while Alan Greenspan was boss of the US Federal Reserve. It was serious boom time. Loads of cheap cash, and interest rates kept far too low for too long, sent the p/e on the S&P far higher than that long-term average.

Twice now the valuation and the index have been crushed: after the dotcom boom and in 2008. Yet the latest rally has pushed both the S&P p/e and stock prices right back up yet again. The index is now over 1,100. Just to return to the top of the long-term average range would mean the US market dropping by about a third.

I’m not suggesting that a plunge on such a scale will take place next week. The index has managed to stay ‘overvalued’ for so long, it could remain there for a while yet. But with the next move in US interest rates bound to be a rise, the market overall does look toppy – and ripe for a fall.