More on “Shiller PE” Fears by Todd Sullivan, ValuePlays

I’ve posted before my thoughts‘ on the total irrelevance of the “Shiller PE” and since I’ve seen it popping up again out there recently, I thought I’d review it again….

The short version for those who do not want to read the whole post is that FAS 157 (2007) has skewed earnings so materially that any comparison of “PE’s” before then and after is an apple and oranges comparison. So, trying to draw any conclusions from that in terms of market valuation also makes no sense as you are not comparing similar data…

“Davidson” submits:

The issue of using avg. P/Es to value markets is that close examination of markets over our history shows that markets have low P/Es when inflation is high and high P/Es when inflation is low. This is because Value Investors apply an inflation discount to returns such that 10%+ inflation resulted in P/Es below 8 in 1974 and 1982 at market lows when Value Buyers have their greatest impact. We saw P/Es of 21+ in 1998 when inflation had collapsed to ~2%. The relationship is the basis for the creation of the SP500 Intrinsic Value Index.

The mistake many investors make is in not recognizing the P/E-Inflation relationship This is precisely why one cannot average P/Es during high inflation periods with our low inflation period today and claim that markets are trading at a high and risky P/E level. Today, inflation is trending at 1.6%. Adding this to the long term US Real GDP growth of ~3% gives a capitalization rate of ~4.6%. Applying this to the long term median  earnings trend for the S&P 500 gives us $1,912. The SP500 is within spitting distance at $2,020. That is Fair Value!!

Shiller PE

The history of markets is that they always over do it! It is basic market psychology being driven by continued good economic news and most investors not knowing any better investing with ‘the trend is your friend’ mentality. This time around if we repeat recent history we could see S&P 500 near or over $5,000 in 2019-2020. Fair value in 2020 can be calculated using the fundamental trends in place today and assuming that inflation remains at 1.6% (guaranteed that inflation will change the next 5yrs but no guarantee in what direction) comes to $2,725. Obviously, if the SP500 trades much above this level, it will be due to market psychology turning positive.

Markets do not stop climbing till economic activity reverses. History shows that one can see this coming up to 24mos before the market peaks in auto sales, housing sales and demand for labor indicators, i.e. Help Wanted Online, Temp Help, Job Openings and etc.

Investors should be jumping in with both feet and both hands grabbing high quality values. Caterpillar, $CHX, Exxon Mobil, Lennar, Toll Brothers, Bank of America, Danaher, EOG Resources, Oasis Petroleum and a host of other cyclical issues which have come under pressure the past few months of  panic.