A most important problem when trying to assess equity valuation, is that earnings often go all over the place, notably around recessions. Dividends are much more stable in the short run but they are subject to dividend distribution policy. Cash flows are not, and they are more stable than earnings as can be seen on the following chart (data from the BEA):
So let's chart what I would call the "cash flow yield" on U.S. equities, using this previous series (U.S. corporate net cash flows) and the market value of domestic corporations given by the Fed in its Z1 report:
The period average stands at about 13%, compared with today's 10%. So equities are 30% more expensive than during the past half century average using this measure. But note: if we excluded the bubble years of the past decade, the average would have been more in the area of 15%-16%. So stocks would be 50% overvalued at today's levels.
Using the more volatile (thus less reliable) corporate profits series, the picture is even bleaker: equities are more expensive than at any time in the past 50 years except for the bubble and a brief period in the late 1960's.
The last point I want to make concerning this subject is that, even at the bottom of the bear market earlier this year, stocks were never trading at "dirt cheap" levels such as those seen in the late 70's and early 80's.
That being said, markets can remain overvalued for extended periods of time. The only sure thing about today's valuation levels is that a buy-and-hold investor will not see a great performance of his portfolio in the long run. It does also increase the probabilities of a sell-off, as well as the extent of any sell-off should it occur. But since market breadth and internals have recently been very good, I believe the odds are for even higher prices in the short term. My opinion could change rapidly though.
Note: I will update my 2010 GDP forecast in the next few days.
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