According to Bloomberg's calculations, the trailing 12-month PE ratio of the S&P 500 (17.4) is only slightly above its long-term average (16), and far lower than its 2000 peak of 30. My read of this is that equity valuations are about average—neither over- nor under-valued.
The chart above compares the earnings yield on the S&P 500 (the inverse of the PE ratio) to the yield on BAA corporate bonds. On this basis, holding stocks gives you a slightly better yield than holding the typical corporate bond. From an historical perspective, what this means is that stocks are unusually attractive relative to corporate bonds. Why? Because equity ownership gives you unlimited, long-term upside potential, whereas the best you can get from holding corporate bonds is their yield to maturity. It also implies that the equity market is still possessed of a healthy degree of pessimism. Why? Because if investors were optimistic about the prospects for corporate earnings they would much prefer to own equities than corporate bonds, since equities promise not only yields but capital gains.
The chart above compares the earnings yield on stocks to the inverse of the real yield on 5-yr TIPS. These two series tend to move together, and they are good proxies for the degree of pessimism/optimism in equity prices. For example: when optimism was high in 2000, real yields were very high (meaning TIPS prices were very low) and earnings yields were very low (meaning equity prices were very high). The world was so enthusiastic about the prospect for corporate earnings and economic growth that investors were willing to all but ignore the historically attractive and government-guaranteed 4% real yields on TIPS, in favor of the non-guaranteed 3.5% earnings yield on stocks. Today, investors seem indifferent to the almost 6% yield on stocks, versus the meager 0.3% real yield on 5-yr TIPS. Pessimism is not hard to find these days.
Investors always have a choice between owning risky stocks or risk-free 10-yr Treasuries. Currently, the earnings yield on stocks is about 350 bps higher than the yield on 10-yr Treasuries. From an historical perspective, this is a relatively rare occurence. My read on this is that investors today are not very confident that corporate profits can hold at current levels. They fear that earnings are going to decline, and so they demand an unusually high premium for holding stocks instead of Treasuries. By this measure, stocks offer attractive valuations for those who believe that earnings are unlikely to fall.
Corporate profits tend to track the growth of nominal GDP over time. Stock prices are theoretically driven by the discounted present value of future after-tax earnings. The market cap of equities (using the S&P 500 as a proxy) should therefore tend to track the inverse of risk-free Treasury yields (because they are the appropriate discount rate). And as the chart above shows, they do. Treasury yields are very low from an historical perspective, but the market cap of equities is not out of line with historical trends, being roughly the same today as in the early 1960s.