Stocks Are Still ~30% Overvalued

The DOW dropped 512 points today.

And that's on top of the several hundred points it dropped last week.

The S&P 500, a broader market measure, is now down more than 12% off its recent peak.

So what does that mean?

Is it a "buying opportunity"?

Over the short-term, who knows? If this carnage keeps up, a panicked Ben Bernanke will probably rush to announce some huge new quantitative easing program. Or Congress will quickly rethink its recent commitment to "austerity" and announce trillions of new spending. And those initiatives might boost stocks for a while.

The bigger picture, however, is less encouraging. Even after the recent plunge, stocks are still about 30% overvalued when measured on "normalized" earnings--which is one of the only valuation measures that works.

Specifically, even after the crash, stocks are still trading at 21X cyclically adjusted earnings, as we can see in the following chart from Professor Robert Shiller of Yale. Over the past century, stocks have averaged about 16X those earnings. So we're still about 30% above "normal."

PE ratio = blue, 10-year interest rate = red Image: Professor Robert Shiller

In recent months, eager to suggest that stocks are "cheap," most analysts have talked about the market P/E ratio relative to next year's projected earnings. And relative to those earnings, stocks do seem modestly "cheap" (12X, or something).

Unfortunately, measuring stock values against next year's projected earnings has a couple of flaws. First, no one knows whether those projections will materialize. Second, and more important, those projected earnings assume that today's near-record-high profit margins will persist.

Over history, corporate profit margins have been one of the most reliably "mean-reverting" metrics in the economy. When margins get extended to super-high (today) or super low (2009) levels, they generally revert toward the mean. This radically changes the PE ratio.

And measured on average profit margins, not today's super-high margins, the stock market is still expensive. (We discuss this in detail here).

Sadly, this doesn't tell you anything about what the market will do next. As you can see in Professor Shiller's chart, the market has spent decades above and below the average.

What this PE ratio does tell you is that stocks still have lots of room to fall--30%, just to get back to normal, much more than 30% if they "overshoot."

And it also tells you that long-term returns are still likely to be sub-par.

Through history, one of the most reliable predictors of next-10-year returns is the valuation level at the beginning of the period. Today's valuation level is not as high as yesterday's. But it's still higher than average.