My thanks to Tim du Toit, founder of EuroshareLab, an excellent Europe-wide stock screening service, for alerting me to this interesting and sensible academic perspective on stock market bubbles – how to measure them, what to think about them, how to react to them. The author is Aswath Damodoran, a professor at the Stern School of Business at New York University. His article includes a number of spreadsheets which readers can usefully adapt to make their own calculations of PE ratios and future returns.
Here are his conclusions:
My view: there is no doubt that the word “bubble” is much over-used and a cover for lots of sloppy or wishful thinking. It obviously makes sense, for example, to adjust PE calculations for the level of interest rates. It is also true that any form of PE ratio remains a poor guide to short term market behaviour, but once adjusted can be reliably used as a measure of the risk of loss over time. Although that risk is clearly rising, the most important point Prof Damodoran makes, in my view, is that you still need a very high conviction that stocks are overvalued before it makes sense to take decisive avoiding action. That time is edging ever closer, but my sense is we are not quite there – yet. Nevertheless future returns from new money invested at these market levels is likely to be below long run averages.