2013 has officially begun and we decided its time to do an update on market valuations for the S&P 500. We have some global market valuation data, which we posted earlier. Readers can also check out the latest data for CAPE across the 32 largest equity markets. We hope to post updates on market valuations levels each quarter. Data from our last update can be found here.
The S&P 500 (S&P Indices:.INX) closed at 1,414 for 2012, for a total return of 16%. The S&P 500 (S&P Indices:.INX) seems to be slightly more over-valued today than it was in the beginning of 2012. The market seemed overvalued at the beginning of 2012, but provided a nice return nonetheless. It is important to remember that just because the market is over or undervalued does not mean that future returns will be high or low. The market can stay irrational for months or even years. Additionally, regardless of the overall market valuation, individual value stocks can be found which will outperform (or underperform the market). However, we think the metrics are useful or at the least, interesting. We use six common metrics to arrive at the S&P 5oo ' valuation '.
We start off with the most common metric, the price earnings ratio (PE) for the trailing twelve months (TTM).
The S&P 500 (S&P Indices:.INX) has a PE ratio of 15.96.
Max:123.79 (May 2009)
Based on the PE TTM the market is basically fairly valued. However, we do not think this is a good way of valuing the market. One example can be seen above, the max (of recorded data is May 2009), which was only a few months from the market low of March 2009. To get an accurate picture of whether the market is fair valued based on price earnings ratio, using several years of earnings seems to be a better indicator.
Numbers from Previous Market Lows:
Shiller PE (or CAPE): 22.53
The Shiller PE, invented by the famous Robert Shiller, 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.
Using ten years of earnings removes the problem we mentioned above regarding PE TTM. CAPE is extremely high currently, using the mean or median.
The most common criticism of Shiller’s method is that it includes years like 2008 and 2009 when earnings were severely depressed. However, we believe that argument shows why the Shiller PE is suprieror to the PE TTM. Furthermore, earnings from depressed years usually are balanced out by earnings from bubble years. In this case, earnings were high due to the housing bubble from 2003-2007. Furthermore, the Shiller PE (with the notable exception of the mid 1990s to 2000) has been a much better indicator of market bottoms and tops than PE TTM. Two recent examples prove this point. In March 2009, the Shiller PE was at 13, while PE TTM was at 110. At the market top in October 2007, the Shiller PE was at an extremely high level of 27+, while the PE TTM was only slightly above 20.
In our opinion, The AAII has put out the best criticism of the Shiller PE.
Below are their 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.
Those points are valid. Additionally, we do believe that Shiller takes a bit too much of a conservative approach. For example, using 5-7 years of earnings may be a better indicator than 10 years (would be great if someone could back-test that). Nonetheless, while Shiller’s method is far from perfect, we think it is still valid and the best method of broad market valuation for the reasons stated below:
- The Shiller PE shows markets overvalued by approximately 40% (at time of the article) and using a six year business cycle (as suggested by the AAII) the market is still overvalued by nearly that amount. This could also be the case historically (again would be great if someone would backtest), but all we have is the evidence in front of us. Therefore, five versus ten years is