Are Stocks Expensive? Depends on Interest Rates

Are stocks overvalued? That question has become increasingly pressing for investors as shares rally to 18-month highs despite major economic drawbacks like persistently high unemployment.

There's no shortage of glib answers, either. "The market is as overvalued now as it was undervalued a year ago," Gluskin Scheff chief economist and noted bear David Rosenberg told The New York Times recently.

Despite his certainty, though, Rosenberg may instead illustrate how hard it is to put a price on the market. Recall that last year he was calling for the market to hit fresh, prolonged lows, rather than urging investors to buy what in retrospect he sees as obviously cheap shares.

Likewise, it's difficult to so easily pronounce the current stock market to be overvalued. And making life that much tougher for investors, commonly used gauges to value stocks like price-to-earnings ratios are often trickier than they seem. Rather than simply glancing at a market metric or taking the latest pundit pronouncement, then, investors are better off understanding this messy reality.

Higher Valuations in Lower Interest Rate Environment

Take something as seemingly straightforward as the price-to-earnings (PE) ratio for the S&P 500, an estimate of how much analysts expect a composite of companies to earn in the year ahead. Trading at a ratio of about 19, the S&P would seem frothy given its historic average of about 16.

Yet shares tend to command markedly higher earnings multiples in low, stable interest-rate environments such as the present, Crestmont Research President Ed Easterling told DailyFinance in an interview.

"High valuations and relatively high price-to-earnings ratios are expected and normal when we have low inflation," Easterling says. Price-to-earnings ratios between the low to mid 20s are the norm for the current interest-rate environment, he says.

Of course, it's tempting to think that average PE measures over a longer term have more data backing them up and are more meaningful. Indeed, some investors scrape together data going back to the earliest days of the stock market looking for clues.

But looking at scenarios where other key factors like interest rates more closely resembling the current environment may be more relevant and predictive. Indeed, looking at just historical averages like price-to-earnings, among other measures, would demonstrate that stocks have been overvalued for more than two decades now -- a span where low interest rates have prevailed. That, in turn, begs the question of what it means for stocks to be overvalued to begin with.

Interest Rates Are Creeping Up

Signs that an economic recovery is mounting, meanwhile, are leading to rising interest rates from rock-bottom levels. There is much hand-wringing about whether rising rates, which no doubt pose a risk, will stall the recent rally. But investors should also note that higher rates would hit the bond market -- where shell-shocked investors have been putting record-levels of cash -- even harder. And that, in turn, could lead to a scramble for the stock market.

"Rising rates may lead a rotation back to equities, writes Jeffrey Rosenberg, Bank of America-Merrill Lynch's head of global credit strategy, in a recent research note. "The continuation of investors' love affair with fixed income in 2010 makes little sense in light of rising interest rates."

Of course, there are major risks to stocks as well. Rumblings of a trade war with China and skittishness among buyers of government debt threaten a nascent recovery. If job growth comes in surprisingly strong, as some in the administration are forecasting, the Fed could raise interest rates much more sharply than anticipated, and the vanishing liquidity would take a toll on share prices.

But that all underscores why investors need to keep an eye on the markets and take often whimsical pundits with a grain of salt.