How Overpriced Were Stocks in 1929?

Scott Sumner recently wrote, “studies have shown that stocks were not overpriced in 1929.” This observation surprises many people. They’ve been led to assume to stocks were wildly overvalued in 1929, but carefully looking at the evidence shows that that really isn’t the case.

While stocks did soar during the 1920s, so did earnings and dividends. Stocks exploded higher in 1929, especially after April. The Federal Reserve also stepped in by raising rates a few times.


The chart above is from data from Robert Shiller’s website. The S&P 500 is the black line and it follows the left scale. The one-year trailing earnings and dividends follow the right scale. The lines are scaled at a ratio of 16-to-1, so whenever the lines cross, the earnings multiple is exactly 16 or the dividend yield is 6.25%.

I think a good way to view bear markets is to divide them into two categories. One is when prices far overshoot fundamentals. The other is when fundamentals crumble beneath prices; 1987 and 2000 are examples of the former, 1990 and 2007 are examples of the latter. I would say that 1929 is another good example of fundamentals falling apart beneath prices. So were stock prices overvalued in 1929? I think it’s fair to say that stock prices became “elevated,” but I don’t believe it was anything truly excessive.

According to the monthly Shiller data, the peak P/E Ratio, based on one-year trailing earnings, was 20.2 in September 1929. That’s high but hardly out of orbit. The dividend yield for September was 3%.

Bear in mind that I’m speaking from the standpoint of an investor at the time. Of course, investors then wouldn’t have known that the Federal Reserve engaged in an historic blunder by tightening as things got worse which, in turn, made things even worse. But for a person in 1929, there was little reason to believe that stock prices had reached the moon. In early 2000, by contrast, it was quite obvious that tech stocks bore little relation to their long-term value. They were going up simply because they were going up. As Herb Stein said about unsustainable trends, they eventually come to an end.

Let me add that any look at the market’s value is inherently subjective. There’s no one perfect measure of something’s worth. After all, if there were one, we wouldn’t need markets. In the end, something is worth how much someone else is willing to pay for it. So I’m not saying stocks were perfectly valued or undervalued in late 1929. I’m saying that there was no obvious signal at the time that stocks were overvalued.

That brings me to Robert Shiller’s CAPE, which is the Cyclically Adjusted Price/Earnings Ratio. That’s the P/E Ratio but based on the average of the last 10 years’ worth of earnings. As I’ve written before, I’m not a fan of CAPE. The issue for me is that stock valuations are inherently cyclical so there’s no need to adjust them for a cycle. With the 1929 example, we can really see the weakness of CAPE.

The problem is that 10 years prior to 1929, the earnings denominator included the earnings plunge of the early 1920s. That really weighs down the data and thereby elevates CAPE. On the chart, notice how earnings dropped below dividends which is a good sign that the data is a bit messy. If the CAPE were five years instead of 10, the picture would look much different. I used one-year data in my chart which I think gives us a better picture of what was truly happening.

Historically, CAPE doesn’t have a great track record. It showed that stocks were rather high in 1995 at the start of the bull market, and it showed that prices were fairly valued only weeks after the March 2009 low.

Recently I wrote about the little-appreciated bull market of 1949-55. I think it’s ignored because it didn’t come to a crashing end. The 1929 market gets the opposite effect. Because it came to a crashing end, people assume stocks were outrageously priced. The ultimate judge of a market shouldn’t be what comes after.

Posted by on February 12th, 2013 at 10:46 am

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