Note: All data refers specifically to the S&P500 (SPY) or the Wilshire 5,000 (VTI)
Below are eight different quantitve valuation metrics for the US equity market.
First a primer:
We are sometimes asked what is the point of measuring the stock marketvaluation, we clarified why I started this monthly piece below. Additionally, Steven Romick of FPA compares the Shiller PE to the ten yr treasury yield to measure market valuations. So there is at least one great investor out there who finds it useful.
You can view extensive European market valuations (including country valuations) here.
We started this monthly market valuation series in December 2009. We were getting tired of hearing that the market was overvalued because P/E TTM was 87. Earnings were clearly lowered 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. We 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.
We were 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, we 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 1,370, and the Dow is at 12,978 — a slight increase from last month.
The point of this article is to measure the stock market based on seven different metrics. As stated above, this article does not look at the macro picture and try to predict where the economy is headed.
As always, we 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 we note at the end of the articlewe 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 March 2nd, 2011:
The current P/E TTM is 15.0, a slight increase from last month (this specific number is from February 29th close).
This data comes from 0ur colleague Doug Short of dshort.com.
Based on this data the market is fairly valued. However, we 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 22.88; a slight increase from PE of 22.47 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. Howeverwe 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 reached 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