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 1,278, and the Dow is at 12,119 — a large drop over the past month. Concerns over the situation in Europe, especially Spain, has led to panic and indiscriminate selling. As the situation in Europe seems to be a spiral, which David Einhorn has described, investors are particularly scared. The Euro-zone makes up 25% of global GDP. Now we will focus on the quantitative metrics and ignore the noise from Europe and DC.
The point of this article is to measure the stock market based on eight different metrics.
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 are getting more optimistic about the long term return for the market based on the most recent numbers.
The current P/E TTM is 14.7, a slight decrease, and below its historic average:
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 is 20.53
The current ten-year P/E is 20.53, a significant decrease from PE of over 23 from just a few weeks ago. More on this below:
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 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 P/E).
- Same point with accounting changes. Accounting changes would also effect P/B or ANY metric that is used to value the market, this is not limited to Shiller PE.
- Shiller PE has proved to be a good market valuation indicator. Shiller stated on February 22nd, 2009, that based on CAPE equities were cheap for the first time in decades. That was only two weeks before one of the biggest bull market rallies in history.
Below is some further data showing how accurate the Shiller PE has been in predicting future market returns. First how has Shiller PE been in terms of predicting future returns in the past: