Stocks Cheap? According to Shiller's Cyclically Adjusted PE Ratio We're Approaching Peak Valuations Before Serious Corrections

By @ibtimes on

Most of the commentary in regards to the value of stocks looks at the 1 year trailing or forward PE ratio, and applies some sort of premium or discount to that due to interest rates.  Indeed with estimated earnings in the mid $90s on the S&P 500 and record low interest rates the market looks relatively 'cheap' at around 13x end of year 2011 estimates.  As always please understand the market is substantially more expensive than the raw numbers show as many companies take numerous exemptions for 'one time' expenses such as options expensing - which are of course not one time.... but Wall Street still is happy to exclude these very real costs in the game of wink wink.

Of course this mid $90s S&P 500 target is in an environment where steroids are running through every vein of the system.  Massive global government spending (including record levels in the US), the cheapest money in our history, record profit margins as labor wages are pressured, and record low taxes by corporations as a % of GDP.  All things that in theory should revert to a mean over time.   Hence a longer term view might be of use.  This is where the Cyclically Adjusted Price Earnings ratio, originated by the highly respected Yale University professor Robert Shiller comes in handy.  According to this measure the market is 43% over its long term average value, and at levels seen only 4 times before: 

  • The late 1920s, right before the 1929 stock market crash

  • The mid-1960s, prior to the 16-year period in which the Dow went nowhere in nominal terms and was decimated in inflation-adjusted terms

  • The late 1990s, just prior to the popping of the internet bubble

  • The period leading up to the October 2007 stock market high, just prior to the Great Recession and associated credit crunch.

Does that matter immediately?  No - very high valuations can beget even higher valuations - and this can continue for a long period ... as always it doesn't matter, until it does on Wall Street.  Indeed, CAPE peaked at 40 during the Alan Greenspan flooding of the system with liquidity in the late 90s.  More important is to realize that the market is cheap argument has some holes in it when we take a longer term view - unless we assume nothing reverts to a mean in the new paradigm Fed supported stock market.

  • There have been only four other occasions over the last century when equity valuations were as high as they are now, according to a variant of the price-earnings ratio that has a wide following in academic circles. Stocks on each of those four occasions would soon suffer big declines.  
  • This modified P/E was made famous in the late 1990s by Yale University professor Robert Shiller, particularly in his book “Irrational Exuberance.” In this modified P/E, the denominator is not current earnings per share but average inflation-adjusted earnings over the trailing 10 years. This modified ratio — sometimes called P/E10, or CAPE (for Cyclically Adjusted Price Earnings ratio) — has a markedly better forecasting record than the simple P/E. 
  • According to Shiller’s website, the CAPE currently is 23.5, or some 43% higher than the CAPE’s long-term historical average.
  • Perhaps the bulls’ best argument, in the face of the current high CAPE level, is to point out that valuations can remain high for some time before they come back down to earth. The CAPE at the height of the Internet bubble in early 2000 was above 40, for example. And it was above 30 right prior to the 1929 stock market crash. Compared to those two lofty levels, the current CAPE might suggest that the bull market still has room to run.

Source: Marketwatch

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