Stocks have soared since Donald Trump was elected president, continuing a trend of rising prices that began in 2009. The Dow Jones Industrial Average is at record highs. U.S. house prices are back to pre-crash levels. This naturally has a lot of people worried that financial assets are overpriced. If so, asset managers and investors should be shifting money into cash. Is this worry appropriate or overhyped? It’s always hard to tell with asset prices -- if they were predictable, it would be too easy to make money in the market. But data can give us a few hints, and theory can elucidate some of the reasons assets might be cheap or expensive.
Any model of asset pricing starts with a prediction of expected returns. Usually, people think of this as a historical average -- U.S. stocks have returned about 7 percent a year on average, in inflation-adjusted terms, since the 1870s. But assuming that the future will look like the past isn’t the best forecasting method. When the ratio of stock prices to fundamental values -- measured by corporate earnings -- goes way up, it tends eventually to come down. The reversion isn’t certain -- stocks can stay high relative to fundamentals for a long time, and the average ratio does change slowly over time. But in general, if the ratio of price-to-earnings is higher than normal, it means the expected returns from stocks are lower during the next couple of decades. This is the finding that won economist Robert Shiller the Nobel prize.
