Thursday, April 1, 2010

Are Stocks Expensive Today?

Investors determine how cheap or expensive a stock is by using a metric called a P/E ratio.  P/E means Price to Earnings, and it is simply the price you pay for a company in relation to how much money that company makes.

Robert Shiller, the Yale economist, has recently put together a long term chart showing how "expensive" the stock market is going back to 1881.

He divides the market into 5 sections with the 5th being the cheapest and the 1st being the most expensive.  As you can see by the chart, stock prices have just crossed back into the most expensive sector:


Does this mean that stocks will not continue to go up?  Of course not.  As you can see by the chart, other than a brief period last year stocks have been very expensive since 1995, and the market has the ability to stay irrational for much longer than people expect.

However, the following chart shows the average 10 year performance for investors, depending on which section they chose to enter the market in. 


The average return for an investor entering in the red? 1.7%

The average return for an investor entering in the grey?  11%

I prefer to buy things when they are cheap, and this chart shows the market as extremely expensive.

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