I am sometimes asked what is the point of measuring the stock market valuation, I clarified why I started this monthly piece below. Additionally, Steven Romick of FPA looks at long term market valuation parameter Shiller P/E for market valuations. He compares the Shiller PE to the ten yr treasury yield to measure market valuations.
You can check out extensive European market valuations (including country valuations) here.
I started this monthly market valuation series in December 2009. The motivation for the article was that I was getting tired of hearing that the market was overvalued because P/E TTM was 87. This was ridiculous because earnings were deflated by the worst economic crash since the great depression. However, the question was how to value the market from a purely quantitative methodology, while ignoring all the outside noise and macro predictions of where the economy is headed. I looked for several different metrics to evaluate the market which over time have proven to be effective and decided to look at all the metrics, instead of just focusing on the last 12 months of earnings.
I was contemplating only updating the valuations on a quarterly basis, since why is there a need every month? However, since the market was and in general continues to be quite volatile, I consider it useful to evaluate on a monthly basis. When volatility truly gets to lower levels, it will suffice to update these series on a quarterly basis.
The current level of the S&P500 is 1,277, and the Dow is at 12,397 — a slight increase from last month.
I update market valuations on a monthly basis. The point of this article is to measure the stock market based on seven different metrics. This article does not look at the macro picture and try to predict where the economy is headed.
As always, I must mention that just because the market is over or undervalued does not mean that future returns will be high or low. From the mid to late 1990s the market was extremely overvalued and equities kept increasing year after year. In addition, individual stocks can be found that will outperform or underperform the market regardless of current valuations. However, as I note at the end of the article I expect low returns for the overall market, over the next 10 years based on current valuations when the metrics revert towards their mean.
Below are different market valuation metrics as of January 1st, 2011:
The current P/E TTM is 13.8, unchanged from last month (this specific number is from Oct 31st close).
This data comes from my colleague Doug Short of dshort.com.
Based on this data the market is fairly valued. However, I do not think this is a fair way of valuing the market since it does not account for cyclical peaks or downturns. To get an accurate picture of whether the market is fair valued based on P/E ratio it is more accurate to take several years of earnings.
Numbers from Previous Market Lows:
The current ten-year P/E is 21.37; slight increase from PE of 20.98 from the previous month. This number is based on Robert Shiller’s data evaluating the average inflation-adjusted earnings from the previous 10 years.
The Shiller PE is calculated using the four steps below:
- Look at the yearly earning of the S&P 500 for each of the past ten years.
- Adjust these earnings for inflation, using the CPI (ie: quote each earnings figure in 2011 dollars)
- Average these values (ie: add them up and divide by ten), giving us e10.
- Then take the current Price of the S&P 500 and divide by e10.
The common criticism of Shiller’s method is that it includes years like 2008 and 2009 when earnings were awful. However I would argue that it is balanced out by the bubble years of 05-07. Additionally the Shiller PE (with the exception of 1995-2000, where the stock market went up to absurd valuations) has been a much better indicator of market bottoms and tops than PE TTM. Two recent examples:in March 2009, the Shiller PE was at 13, while PE TTM was at . At the market top in October 2007, the Shiller PE was at a very high level of 27.31, while the PE TTM was only at 20.68.
The AAII put together the best criticism of the Shiller PE, which I have seen to date.
Below are the main points:
- Following the Graham-Dodd recommendation, Shiller uses a 10-year moving average of earnings in computing the CAPE. According to data compiled by the National Bureau of Economic Research, economic contractions have become shorter and expansions longer in recent years. Measured peak to peak, the average is five years and six months.
- In determining the CAPE (Shiller PE), reported earnings are adjusted for inflation using the Consumer Price Index, where real values reflect current-period purchasing power. However Shiller uses data going back to 1871, when inflation was measured differently than today. There is an approximate 7% difference in the annual CPI inflation rate based on methodological changes over the last couple of decades.
- Tax codes have changed considerably since 1871. You can read further discussion of this issue above.
The criticisms are fair, and I do believe Shiller takes a more cautious approach to market valuations (Shiller can be described as a bit too cautious and overshoots on valuations). While Shiller’s method is by no means perfect, I think it is still a valid and the best method of market valuation for the following reasons.
- The 10-year Shiller PE shows markets overvalued by about 43% (at time of the article) and using a 6 year business cycle the market is still overvalued by 35% at time of writing. still shows it overvalued by about 35%. This is not a large difference to completely throw out Shiller’s methodology.
- Differences in inflation may effect the Shiller PE, but they would only have a small effect, especially if you decrease the earning duration. Also they should apply to any PE (TTM, six-year P/E, or forward P/E).
- Same point with accounting changes. Accounting changes would also effect P/B or ANY metric that is used to value the market, this is not limited to Shiller PE.
- Shiller PE has proved to be a good market valuation indicator. Shiller stated on February 22nd, 2009, that based on CAPE equities were cheap for the first time in decades. That was only two weeks before one of the biggest bull market rallies in history.
Below is some further data showing how accurate the Shiller PE has been in predicting future market returns. First how has Shiller PE been in terms of predicting future returns in the past:
In conclusion to the argument about using CAPE, I would say that the Shiller PE despite slight flaws is a great metric for predicting future long term returns of the market.
Robert Shiller stated in an interview that he believes the S&P500 will be at 1430 in 2020. Shiller believes that based on his metric the market is overvalued, and will offer subpar returns over the next 10 years. However Shiller noted in another more recent interview that the market is not too overvalued, as it has been over the past year. He also noted the ultra low interest rates, which make equities much more attractive. Shiller expects real returns of several percent a year, although below the 7% real return, which the market has historically returned.
|Stock Market||Best Possible||Lucky||Most Likely||Unlucky||Worst Possible|
|10-Year Percentage Returns||9.31||6.31||3.31||0.31||-2.69|
|20-Year Percentage Returns||8.14||6.14||4.14||2.14||0.14|
|30-Year Percentage Returns||8.60||7.60||6.60||5.60||4.60|
|40-Year Percentage Returns||7.41||6.51||5.61||4.61||3.61|
|50-Year Percentage Returns||7.40||6.60||5.80||5.10||4.40|
|60-Year Percentage Returns||7.69||7.04||6.39||5.79||5.19|
Based on Rob Bennett’s market return calculator, the return of the market should be 3.31% annually over the next ten years under the mostly likely scenario.
This new calculator tells you what return you can reasonably expect at various time-periods from an investment in the S&P stock index, presuming that stocks perform in the future much as they have in the past. The results are expressed in terms of real, annualized total (that is, with dividends reinvested and without additions or subtractions to principal) returns.
Min: 4.78 (Dec 1920)
Max: 44.20 (Dec 1999)
Numbers from Previous Market lows:
Mar 2009 13.32
Mar 2003 21.32
Oct 1990 14.82
Aug 1982 6.64
Oct 1974 8.29
Oct 1966 18.83
Oct 1957 14.15
June 1949 9.07
April 1942 8.54
Mar 1938 12.38
Feb 1933 7.83
July 1932 5.84
Aug 1921 5.16
Dec 1917 6.41
Oct 1914 10.61
Nov 1907 10.59
Nov 1903 16.04
My colleague Doug Short thinks the Shiller’s numbers are a bit inaccurate because the number used above does not include the past several months of earnings, nor revisions. Doug calculates P/E 10 at 20.5.
Data and chart courtesy of [multpl.com]
Current P/BV ~2..09