The stock market is taking a hit as investors choose to sell overpriced stocks at the start of 2015. Fundamental analysis of intrinsic stock value is how successful long term investors determine whether to buy stocks with value or sell overpriced stocks. A common approach is to compare the P/E ratio of a stock with that of others in its sector. A newer approach is to use the Schiller P/E which currently tells us that the US stock market is grossly overpriced!
What Is the Schiller P/E?
P/E ratio stands for price to earnings ratio. Investopedia says:
P/E is short for the ratio of a company’s share price to its per-share earnings. As the name implies, to calculate the P/E, you simply take the current stock price of a company and divide by its earnings per share (EPS):
P/E Ratio = Market Value per Share / Earnings per Share (EPS)
Most of the time, the P/E is calculated using EPS from the last four quarters. This is also known as the trailing P/E.
How is the Schiller P/E ratio different? The earnings per share in the Schiller P/E ratio are the average inflation adjusted earnings for the preceding ten years. The point is that the Schiller P/E ratio gives the investor a better perspective about the earnings of a company over time and not just during the run up of a bull market.
Why Stocks May Fall
Fortune discusses why stocks may tank in the coming year.
One of the best arguments for why 2015 will be bad for the market is that stocks are really expensive. These days, the preferred measure is the Shiller P/E, which is named after the Nobel Prize winning economist Robert Shiller and compares stock prices to the past decade of corporate earnings. By that measure, the market is at 26, well above its 130-year average of 16, and close to where the market has cracked in the past. In mid-2007, the Shiller P/E topped out at 27.5.
This argument makes the point that stocks are overpriced compared to earnings by historic standards. When this happens it typically precedes a large correction or even a market crash. If you believe this line of reasoning it is time to sell overpriced stocks.
If you expect the stock market to fall it sometimes makes sense to invest in bonds. Interest rates are not all that high and unless they go up precipitously it is unlikely that you will lose much money compared to what would happen in a market crash with your stock portfolio. It may be a harbinger of things to come that investors are choosing to sell overpriced stocks and buy bonds. CNN Money notes that investors run to bonds in this situation.
The yield on the U.S. 10-year Treasury note has been on a post-holiday weight loss plan. It was around 2.25% the day after Christmas. It touched a low of 1.89% on Tuesday.
Stocks and bonds move around all the time, but the 2% yield is a red-flag threshold. It means that investors are basically willing to accept an interest rate on a bond that will lose them money in the long-term, since U.S. inflation typically hovers around 2%.
If you have been in the stock market during its upward ride for the last few years it may be time to take a little money off the table, sort through your portfolio using the Schiller P/E ratio, and sell overpriced stocks before they become underpriced!