Stock traders need to know when stocks are priced too low, priced normally, or overpriced in order to time their trades. Today the market as a whole has recovered from the Covid-19 crash at the beginning of the year. Some stocks like the tech giants are thriving while others like airlines, tourism, hotels, energy, and others are still hurting. The real question for traders is if the market is priced too high and ready for a big correction. True, the Stock market is excessively priced according to normal measures like the P/E ratio but not so bad if you use an Output Gap Adjusted P/E. This implies that the current rally has room to run.
How Accurately Value Stocks Today
Market Watch writes that the market may be at a more reasonable valuation than many believe. As evidence, they cite the Output Gap adjusted P/E as opposed to the standard P/E ratio.
Nontraditional ways of assessing how pricey stocks have gotten may be warranted, given the nature of the biological disaster that helped to spark the rout in markets back in March.
They cite the output-gap-adjusted P/E multiple, or OGA P/E, which calculates the percent difference between the current level of real gross domestic product and its estimated potential level if the economy were operating at full employment and adjusting the trailing P/E based on the degree to which the output gap trails the average since 1950.
The point of their discussion is that once the virus has been beaten back by medications and vaccines, employment will likely resume at higher levels and production will go up substantially. If this is indeed the case, the output gap adjusted P/E ratio is a more accurate indicator of the relative value of the market today than a standard P/E ratio.
How Successful Will a Vaccine Be in Restoring the Economy?
We believe that there is some value to the variation in calculating the P/E ratio to get an accurate view of true stock values today. However, the current optimism is largely based on the assumption that one or more of the many vaccines under development today will save the day. This optimism misses the fact that as many as a third of Americans will not take a vaccine when it becomes available according to polls! Another issue is that no vaccine has passed the third phase of FDA-required trials. We would like to assume that vaccines will start becoming available by the end of the year but if you look back to the rush to produce a vaccine for the Swine Flu back in the 1970s you see that there were thousands of cases of Guillain-Barre Syndrome (total body paralysis) that were caused by the virus. Thus we are waiting for results of phase 3 testing to be assured that any or all of the vaccines are indeed safe to use and likely to help prevent the disease.
If the vaccines work and the GDP roars back to normal levels, the output gap adjusted way of measuring P/E ratios may be a better indicator of the true forward-looking value of stocks today.
