Why are investors complacent with stock prices so high compared to earnings?

While Bay Area traffic congestion is up 60 percent over the past four years, it is the price we pay for floating on the rising tide of this vibrant economy.

Thanks to the performance of major local companies, we have dodged the bullet known as “the summer doldrums” — a term describing the usual stock market downdraft occurring more often than not in the summer months. For the past 30 years, the market has typically experienced an average 14 percent drop at some point during the year, but the most we have endured this year was a 2.6 percent decline back in April.

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While long-term stock market gains average an annual 10 percent (including reinvested dividends), it is helpful to know that this does not happen like clockwork. The S&P 500 index has generated annual returns between 5 percent and 10 percent just three times over the past 30 years. More substantial gains and losses are the norm.

What stock market investors earn beyond what would otherwise be guaranteed money market rates is called the “risk premium.” It’s the reward for enduring the market’s volatility. Like gravity, it is the natural phenomenon that has to be a condition before anyone would step up to own some portion of a company. From a hall-of-mirrors perspective, volatility is a good thing.

So how do we explain investor complacency today when cyclically adjusted price-earnings ratios are at 30 to 1? The long-term average for the P/E ratio is 16.8 from 1881 to the present. This means that investors …read more

Source:: The Mercury News

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