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How to tell if stocks are overvalued

Rick Newman
Senior Columnist

One of the biggest debates among investors right now involves stock values. Are we in a bubble that’s about to burst? Or are stock prices reasonable, with plenty of room to run?

By one conventional measure, stocks are pricey and due to fall. The price-to-earnings ratio for the S&P 500 index is around 23, well above the historical average of 15. That suggests that either prices must drop for the market’s P/E ratio to return to trend, or earnings must rise sharply, which seems unlikely in an economy stuck at around 2% annual growth.

But that only tells half the story, market historian Sam Stovall of CFRA says in the podcast above. “The other half is inflation,” Stovall says. “And if inflation is at 1.7%, we can afford a much higher P/E ratio.” (You can download the full podcast from sites such as Apple, free of charge.)

If he’s right, then corporations will most likely continue to benefit from low interest rates and reasonable labor costs, without the kind of sharp wage growth that usually triggers price and interest-rate hikes. Workers may not get ahead as quickly as they would with bigger wage gains, but the Federal Reserve won’t have to abruptly tighten monetary policy, either, helping prolong an economic recovery and stock-market rally both in their ninth year.

Stovall measures inflated-adjusted P/E ratios using something called the Rule of 20, which he explains in the podcast; it’s a useful metric savvy investors might want to know. That measure is more reassuring, showing that stocks may be a bit overvalued this year — but a bit undervalued next year. For investors, that’s a bullish sign that can justify staying in the U.S. stock market, or perhaps even investing more.

It goes without saying there are always risks in the stock market, and investors who can’t afford to risk losing money should invest in safer assets, no matter how certain they feel about the market going up. Even now, it probably pays to spread your money around. While the U.S. market could continue to prosper, many foreign markets lag the U.S. recovery, suggesting stocks could rise more overseas as the laggards catch up to the American recovery. “International stocks look a lot more attractive than domestic ones,” Stovall says in the podcast. “Provided we don’t fall into a bear market in the United States, then I think better gains could be found overseas.”

(You can find this podcast and others from Yahoo Finance on iTunes, Google Play, Stitcher or acast.)

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Rick Newman is the author of four books, including Rebounders: How Winners Pivot from Setback to Success. Follow him on Twitter: @rickjnewman