The Real "Price" of Stocks

“Investors need to understand the long-term trends in stock valuations,” writes Dan Amoss. Starting valuation is crucial to your investing results. Overpaying for stocks near the peak of bull markets is a surefire way to lose money.

“One of the best methods of stock market valuation is based on the work of Yale professor Robert Shiller and his now-famous “Shiller P/E ratio.” The Shiller P/E ratio is calculated as follows: Divide the S&P 500 by the average inflation-adjusted earnings from the previous 10 years. Here is a chart of the Shiller P/E going all the way back to 1880:

“This is the best P/E ratio to use over long stretches of history, because it smoothes out the extreme peaks and valleys in earnings, giving a better framework for thinking about future S&P earnings power. The mean and median Shiller P/E since 1880 are both about 16. Today, it’s about 22. At the last four major bear market bottoms, in 1921, 1932, 1949 and 1982, the Shiller P/E fell all the way into the range of 5-10. This is a far cry from bouncing sharply off of 15 -- which we saw at the March 2009 bottom.

“Valuation is the main reason why I expect the bear market to last several more years into the future -- probably somewhere in the 2015-2020 time frame. I think we’ll get there through some combination of falling stock prices and modest earnings growth. Rising Treasury yields should drive stock valuations lower.”