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