The stock market is overvalued and there is a very easy way to tell: the Shiller S&P 500 PE ratio.
Robert Shiller is an American economist and professor at Yale University. He is ranked one of the top 100 most influential economists in the world and recently won the Nobel Prize in Economics for his contribution to the empirical analysis of asset prices. Shiller also developed his own price-to-earnings ratio (also referred to as the “PE ratio”) and charted the ratio all the way back to the 1900s using the S&P 500 index.
The PE ratio is an equity valuation multiple and is defined as the market price per share divided by the annual earnings per share. Another way to think about the PE ratio is how much return an investor is expected to gain based on his/her investment. For example, if a stock has a PE ratio of 10, that means the the investor is paying $10 for $1 of earnings, which implies a 10% return on investment. Overall, the Shiller PE ratio, which is based on the average inflation-adjusted earnings from the previous 10 years for the S&P 500, stands at 24.82 today– but the historical mean of the PE ratio is 16.5.
If you look at the Shiller S&P 500 PE ratio plotted over time, you can see the S&P 500 PE ratio increases significantly right before a market crash. Valuations are rising faster than earnings. This is how you can tell if the market is overvalued. The real problem is knowing when the market will revert back to the mean, because if you time it right, you could be in for big gains. Below is a graph of the Shiller PE ratio since 1880.