How High Are Stock Prices?

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The NYT tells us that the price-to-earnings ratios in the stock market are just 16.8, only a bit higher than the long-term average of 15.7. This might make the stock market sound reasonably safe right now, but this misses an important piece of information. Profits are currently at a cyclical high. Profits fluctuate hugely over the course of the business cycle. For example, the Congressional Budget Office (CBO) projects that profits will revert to their trend share of output over the next several years, so that in 2017, real corporate profits will be just 13 percent higher than in 2006. If this proves right, and stock prices rise in step with corporate profits over the next decade, it implies that real returns in the stock market will be just over 4 percent annually. By comparison, a completely riskless inflation indexed treasury bond pays a return of 2.6 percent. This means that, if the CBO profit projections are in the ballpark, stockholders will receive a very low risk premium over the next decade.

--Dean Baker

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