Are US stocks crazily rich, as some analysts suggest?
Beauty is in the eye of the befuddler
It’s not just the valuation of an asset, but the risk attached to holding an asset, that counts. The Beirut stock exchange is trading at a price-earnings ratio of just 5.6X, with a dividend yield of 8.6%, but I don’t see buyers lined up along the beachfront.
Here’s a simple risk-reward calculation: we divide the forward earnings yield of the S&P 500 (the inverse of the P/E ratio) by the VIX index, the implied volatility of index options. The earnings yield 12 months ahead is a rough proxy for expected return (how many dollars of earnings you get for $1 of stock). Volatility is a proxy for risk. This is something like the “Sharpe Ratio” used to calculate portfolio risk-return.
Neither of our measures are perfect, but the point is to see how today’s market compares to history. The ratio’s average since 1990 is about 0.38, and now stands at 0.3. That’s a bit below the average, but not ridiculously so. During the 1999 stock bubble the ratio fell to just 0.1. Nor is the market stupidly cheap as it was in 2011. It’s on the rich side (which is why we favor cheaper, high-growth markets in Asia), but a rational case could be made to own US stocks.