The current P/E ratio for the S&P 500 is 28.83[1] The long-term average is just under 16.[2] The obvious conclusion is that the stock market is way overvalued right now.

Right?

Right?!

Not so fast. We're missing something...

Interest Rates Matter

Looking at the current P/E and comparing with the historical average is a good place to start, but it hides one incredibly important factor: interest rates. In a 2017 interview with CNBC[3], Buffett awknowledged the importance of interest rates:

"Measured against interest rates, stocks actually are on the cheap side compared to historic valuations. But the risk always is interest rates go up, and that brings stocks down." -Warren Buffett

People were calling stocks in a "bubble" in 2012, 2017, 2019, and -- again -- in 2021. But, most of the time, they are only looking at current P/E ratios compared with historical averages. That is an incomplete way to look at valuations; we must consider interest rates.

Since 1960, the 10-year US Treasury yield averaged 5.8%.[4] If the 10-year US Treasury yield would go from its current 1.4% up to 5.8%, then it would be fair to consider the long-term average P/E ratio. Since it is nowhere near its long-term average, we have to consider that in our valuation assumptions.

So, if we can't simply look at past averages, what can we do? 

I sought to find out what the appropriate P/E ratio might be for the S&P 500 at various interest rate levels. To do that, I took 1960-2021 data from Robert Shiller's website and ran some regressions on it.

I used the trailing earnings per share combined with the prevailing 10-year US Treasury yield to estimate what the fair value of the S&P 500 would have been every month since 1960.

Here's what the chart looked like:

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Below are the statistical measurements. In a nutshell, this suggests that the 10-year US Treasury yield combined with trailing 12-month earnings per share predicted roughly 82% of the long-term movement in the S&P 500's price. All variables were stastistically signnificant at the 99% level.

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What P/E is Correct?

Using the coefficients, I calculated what the current fair value P/E for the S&P 500 would be today at a 10-year US Treasury yield of 1.416%. Based on that model, the fair P/E of the S&P 500 would be 27.2. If we applied that assumed P/E with the current EPS number from Shiller of $161.62, we arrive at a fair value for the S&P 500 of 4,396.

The S&P 500 is currently trading at 4,585 -- approximately 4% higher than this analysis suggests that it should be. Keep in mind that this is just a statistical model; it's not perfect. If we account for the likelihood that this model is off in one direction or the other, it's hard to make a meaningful conclusion that the market is overpriced right now.

The only way the market could be overpriced here are if either:

1. The actual earnings power for the S&P 500 is not $161. If that number is inflated for whatever reason and the actual earnings power is $130 -- then the valuation would be substantially lower. (Which is why stocks go down in a recession -- because earnings go down.)

2. The 10-year US Treasury yield is going to go up significantly from here. If that happens, it would be like turning up the "gravity" on stocks and pull the market lower.

If either of the above would happen, then stocks are signficantly overvalued here. How much? I'm not going to get into earnings (yet), so let's start with interest rates.

What if Interest Rates Go Up?

To find out, I re-ran the calculation using various different interest rates at +/- 1% increments.

Here were the estimated P/E ratios at each 10-year US Treasury yield. You can see that a higher 10-year US Treasury (left column) results in a lower P/E ratio (right column):

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If interest rates were to go up by 1%, the fair P/E drops by about 9%. 

OK, but how does that actually translate to today's stock prices? 

How Would That Impact Stock Prices?

Let's get some real S&P 500 values on this. We'll look at those interest rate environments and what the predicted P/E would be. Then we'll multiply that by the current earnings per share for the S&P 500.

If we do, we come up with the following estimated fair value at different rates:

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If interest rates were to go up near 5.5%, this model suggests that stocks would have roughly 33% downside based on valuations alone.

If, on the other hand, interest rates were to fall below 0.5%, the model suggests that stocks would have even more upside.

Does This Mean You Should Sell Stocks?

OK, so my model is suggesting that stocks are slightly overvalued. And significantly overvalued if interest rates go up. And surely interest rates are going to go up, right? 

Even though this model suggests stocks are trading at a slightly elevated P/E ratio, I don't think valuations alone justify selling stocks here. I consider stocks to be roughly fairly priced right now. Expensive relative to history, yes, but not in the context of the current rate environment.

If interest rates stay below 2%, I don't see why stocks should sell off because of valuation concerns. I certainly don't see any reasonable justification for calling stocks in a "bubble.". If they are, then so are bonds and just about every other alternative asset you could put your money in.

Don't Forget About Earnings Growth

And, remember, the long-term trajectory of earnings is likely higher. As earnings go up, that pulls the value of stocks higher as well. 

Consider what would happen if US earnings grow at a modest pace of around 5% per year for the next decade. The $161 earnings per share number from earlier would increase to roughly $263. Even if interest rates were to go up to over 5%, the fair value P/E of 18.8 x $263 = 4,944. 

Now, I don't think you'd be particularly thrilled with that return; the point is that stocks can handle a rise in interest rates as long as earnings continue to increase. And even if stock prices go nowhere, you will still be collecting dividends that you can use to reinvest in what would likely be a pretty volatile environment.

Are stocks cheap right now? 

No, I don't think so. However, I think the "bubble" narrative is dramatically overblown. The P/E ratio for stocks is elevated, but it should be. As long as rates stay low, there's no reason P/E ratios can't stay high.

Happy investing!

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P.S. - If you want to support the expense of running this blog (about $1,000 per year), you can Buy Me a Coffee or support me via PayPal. This is appreciated, but not necessary; there are no paywalls for any content.

IMPORTANT DISCLAIMER: This article is for educational purposes only. I’m not your financial advisor. I’m not giving you investment, legal, or tax advice. The data I’ve shown here cannot be guaranteed to be accurate. You should always do your own research before making investment decisions. Past performance is no guarantee of future returns. I may own securities mentioned here and take positions within the next 48 hours.

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S&P 500 PE Ratio. https://www.multpl.com/s-p-500-pe-ratio. Accessed 3 Dec. 2021. ↩︎

S&P 500 PE Ratio. https://www.multpl.com/s-p-500-pe-ratio. Accessed 3 Dec. 2021. ↩︎

“BUFFETT: Stocks Are ‘on the Cheap Side’ and Not in Bubble Territory (AAPL).” Markets.Businessinsider.Com, https://markets.businessinsider.com/news/stocks/warren-buffett-stocks-cheap-2017-2. Accessed 3 Dec. 2021. ↩︎

10 Year Treasury Rate. https://www.multpl.com/10-year-treasury-rate. Accessed 3 Dec. 2021. ↩︎