A Price/Earnings Ratio Blinking Yellow?

I should say up front that I know little about financial investment strategies; indeed, all of my retirement assets are in various Vanguard no-load passively managed index funds. But after watching the financial sector jolt the U.S. economy both in recession that followed the dot-com boom of the 1990s and in the more recent Great Recession, I do spend a little more time looking at broad financial indexes than I used to. Here's what's called the Shiller P/E ratio. A P/E ratio looks at the total price of stocks compared with the earnings of companies, and thus gives a sense of how the stock market is being valued.  If you calculate a price/earnings ratio using annual data, then in a dismal economic year like 2008 when profits are very low, the P/E ratio will spike dramatically. To avoid these somewhat meaningless short-term spikes, the Shiller P/E ratio looks the current price of stocks divided by the average profit levels over the previous 10 years, so that it is less influenced by economic conditions this year.

The Shiller P/E is now 24.8. As the figure shows, it is higher than at any time except the peak of the dot-com boom and its aftermath, and Black Tuesday back in 1929 at the front edge of the Great Depression. In other words, when the P/E ratio has reached this level in the past, sometimes it has gone still higher (as in the dot-com boom), but over the last 130 years it has then always fallen back.  



I'm not the right person to ask about what this means from an investment point of view: as I said, I'm a boring index-fund investor. (John Hussman, who knows quite a bit about investments, discusses this pattern over at his website. Full disclosure: Many years back at Stanford, John was a teaching assistant for me and had an office down the hall. We are friends who have fallen out of touch.) My broader concern for some time has been that the extremely low interest rate policies that have been pursued by the Federal Reserve and central banks around the world run a risk of pumping up asset bubbles in other markets, which may pop painfully later on. The IMF has expressed similar concerns, along with Raghuram Rahan (a University of Chicago economist now heading India's central bank), economists at the Bank of International Settlements, and others.