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Is Today's Price-Earnings Ratio Too High?

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Abstract:

More than half of households’ retirement savings are invested in stocks. During the recent financial crisis, stocks lost more than one-half their market value from the fall of 2007 to their lows in the spring of 2009. Since the trough in the market, stock prices have risen to nearly 85 percent of their former peak. Despite this rebound, savers remain relatively wary about holding stocks, and many experts expect weak returns on stocks in coming years.

According to one time-tested standard, the 10-year trend in companies’ reported earnings, stock prices may have risen too rapidly to offer pension funds and other investors attractive returns in coming years. In the past, when prices have been high relative to this measure of cyclically-adjusted earnings, stocks have generally paid investors subpar returns.

This brief takes a closer look at stock prices and companies’ earnings. Although some analysts have proposed alternative ways of measuring cyclically-adjusted earnings, this brief uses the traditional 10-year trend for smoothing reported earnings. It finds that the relationship between stock prices and the traditional trend in earnings has shifted recently as a result of the two recessions since 2000. As this temporary shift reverses, cyclically-adjusted earnings will likely grow sufficiently rapidly in the next several years to bring their relationship to prices back to the long-term average.

The first section of this brief discusses the case for comparing stock prices to the trend in cyclically-adjusted earnings, instead of current earnings. The second analyzes the relationship between the two price-earnings measures. The third section examines the outlook for cyclically-adjusted earnings and stock prices. The final section concludes that the distribution of future returns for stocks currently is aligned with their historical average returns.