Note: All data refers specifically to either the S&P500 (INDEXSP:.INX) or the Wilshire 5000 (NYSE:WFVK)
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 market valuations. We state our own reasons 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.
This article deals with US market valuations. Last month’s data can be found at the following link- March 4th, Stock Market looking expensive.
You can view our extensive European market valuations by clicking here.
We started this monthly market valuation series in December 2009. We were getting tired of hearing pundits claim that the market was overvalued because at the time P/E TTM was 87. Earnings were clearly low due to the worst economic crisis 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 updating the series on a quarterly basis, since why is there a need to update every month? However, since the market was and in general continues to be quite volatile, we currently 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.
While many value investors will totally ignore the total market valuations ratio, they can do so at their own risk. Many investors claim that the overall value of the market does not matter since there will always be cheap individual securities. This is true, but sometimes it can lead to ‘paper’ or even permanent losses. When the tech bubble burst, most value investors did quite well. However, value investors got butchered in the crash of 08, even in the most defensive stocks. We therefore think there is some merit in being at least cognizant of the total market valuation.
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 article, we expect low returns for the overall market, over the next 10 years based on current valuations when the metrics revert towards their mean.
The current level of the S&P500 is 1,408, and the Dow Jones is at 13,212 — 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 at all and try to predict where the economy is headed.
Below are different market valuation metrics as of April 1st, 2012:
The current P/E TTM is 15.2, a slight increase from last month’s 15.0:
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:
Shiller PE – 23.48
The current ten-year P/E is 23.66 an increase from PE of 22.88 from the previous month. This number is based on Robert Shiller’s data evaluating the average inflation-adjusted earnings from the previous 10 years.
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
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 close to 100. 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 we 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 we 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, we 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 (as suggest by the AAII) business cycle the market is still overvalued by 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