Many well-known stock market pundits to include the likes of Henry Blodgett point to Professor Robert Shiller’s cyclically adjusted PE ratio or CAPE to make a case that the stock market (S&P 500) is overvalued. According to Prof. Shiller, the long-term average PE ratio (CAPE adjusted) for the S&P 500 is approximately 16. And today, according to CAPE (cyclically adjusted PE) the S&P 500 sits at a CAPE PE ratio of approximately 24 or so. Therefore, according to the statistical analysis, the S&P 500 is 20% to 30% overvalued.
The thesis of this article is that although Prof. Shiller may eventually end up being correct, and we emphasize “may”, his hypothesis is vague and imprecise, and therefore, too general to be of value. On the other hand, we emphatically hold that he is absolutely wrong regarding specific blue-chip US corporations. Furthermore, we also contend that on an absolute basis (precise calculation of earnings) that the S&P 500 is undervalued based on historical norms.
Therefore, we are concerned that these statistically inferred measurements of so-called overvaluation could deter investors from investing in or owning our best companies at precisely the time when their valuations are low and the long-term rewards for investing in them are better than they have been in decades. Furthermore, thanks to these low valuations the risk of owning blue-chip stocks is simultaneously also lower than it has been in a long time.
What CAPE Really Says
Prof. Shiller's cyclically adjusted PE ratio (CAPE) calculates an average of 10 years of S&P 500 earnings, which is used as the level of earnings with which to divide into the current price of the S&P 500 in order to determine the CAPE PE ratio. This calculation, which theoretically takes into consideration the cyclicality of the S&P 500's earnings, is promoted as being superior to forecasting future earnings. However, we will soon demonstrate that this is precisely what the CAPE measurement is doing; predicting or forecasting future earnings.
Furthermore, the only way that it can be of true value is if its implied forecast is correct in future time. Of course, it should also be recognized that this is no different than any other forecast methodology. The veracity of the assumptions underlying the hypothesis can only be proven if they produce an accurate future level of earnings, in this case for the S&P 500. Also, to be of any real value to investors, CAPE needs to offer a precise point in time when earnings are allegedly going to fall.
Mathematically, the actual forecast behind CAPE in the vast majority of cases is forecasting a lower-level of future earnings on the S&P 500. This is because the S&P 500 earnings are generally increasing and only interrupted by the occasional recession. Therefore, CAPE is suggesting that the S&P 500 is overvalued based on a vague notion about future earnings, not current earnings.
Another claim that CAPE makes as being a superior methodology is that it uses as reported earnings in contrast to operating earnings like most other prognosticators use. According to Standard & Poor's website, the following definitions to these earnings measurements are as follows:
"Operating earnings: income from product (goods and services), excludes corporate (M&A, financing, layoffs) and unusual items."
"As reported earnings: income from continuing operations, also known GAAP (Generally Accepted Accounting Principles) and As Reported
We do not intend to debate which of these earnings measurements represent better reflections of a company's profitability. However, we will emphatically state, that after decades of producing earnings and price correlated F.A.S.T. Graphs™ on individual companies, that the market places a higher correlation on price and earnings with operating earnings than it does with as reported earnings. Therefore, our research tool calculates growth rates and earnings justified valuation lines based on operating earnings.
With the above in mind, and in the spirit of fairness, we have calculated the S&P 500 CAPE valuation based on the 10-year time period 12/31/2001 to 12/31/2010 using both operating earnings and as reported earnings. We chose this time frame because it is the most recent completed 10-year period so all numbers are actual, therefore, no estimates are used. We pulled both earnings numbers directly from the Standard & Poor's 500 index data. Our calculations are as follows:
On an as reported basis, the 10-year average S&P 500 earnings would be $52.03, and by dividing that number into the S&P 500 price on 12/31/2010 of $1257.64, we came up with a CAPE of 24.17. On an operating basis, the 10-year average S&P 500 earnings would be $64.41, and by dividing it into the same S&P 500 price we came up with a modified operating earnings CAPE of 19.5. Both of these CAPE calculations are above the historical normal 16 PE ratio according to Prof. Shiller.
There are several important points to consider here. First, this time frame includes the two recessions of 2001 and 2002. Second, future S&P 500 earnings must fall to CAPE calculated $52.03 (an implicit forecast) in order to validate the overvaluation thesis behind them. That would require an earnings drop in excess of 54%, which is more than even the great recession of 2008. Next,