Nobelist’s Valuation Measure Draws Questions

Nobelist’s Valuation Measure Draws Questions

ALEXANDRA SCAGGS

Nov. 21, 2013 12:06 p.m. ET

Bubble-hunting economist Robert Shiller‘s stock-market valuation measure is waving a yellow flag, but there is a debate brewing over whether even that is too alarming a picture. Of 15 stock-market valuation measures tracked by Bank of America BAC +2.97% Merrill Lynch’s stock strategy team, Mr. Shiller’s cyclically adjusted price/earnings ratio is the only one above its long-term average.The CAPE ratio, which aims to provide a long-term comparison point for stock valuations, uses the last 10 years’ worth of profits and controls for inflation.

“The last 10 years capture the worst profit recession we’ve ever seen,” said Savita Subramanian, head of U.S. equity and quantitative strategy at Bank of America Merrill Lynch. While she says the CAPE ratio is generally a valid way to look at valuations from a long-term perspective, given the past decade’s earnings history, the CAPE ratio is currently a “punitive and unrealistic” framework to smooth out earnings valuations.

Mr. Shiller defends his reading. At current levels, it’s “a concern,” said the Yale University professor who last month won the Nobel Prize. It suggests “you should reduce holdings a bit, that might be reasonable.”

In the meantime, it is possible that “the market could keep going up even more.”

Stocks have risen more than 20% this year and are up roughly 164% from their 2009 low. Investors have been bidding up prices for technology and social-media company initial public offerings, such as Twitter Inc. But at the same time, corporate earnings growth has been slowing and there are worries that the stock market’s gains have been fueled mainly by easy-money policies from the Federal Reserve.

The result has been rising concern among some market watchers that stocks are being lifted by a potentially dangerous bubble, with Shiller’s index seen as one of the early warning signs.

Mr. Shiller, who rose to fame with his book “Irrational Exuberance” and his prediction that the late 1990s stock rally would turn out to be a bubble, created the CAPE ratio as a way to sniff out unsustainable market moves.

The CAPE ratio currently stands at 25.2, which marks the metric’s first foray above 25 since December 2007. However, it remains far below its all-time high of 43.77 hit during the dot-com bubble in 2000.

Mr. Shiller’s long-term P/E isn’t the only one to show stocks in pricey territory. At Goldman Sachs, strategist David Kostin noted in his 2014 outlook released Wednesday that stocks are above their historical average based on the firm’s own cyclically adjusted P/E. Using 10-year average trailing operating earnings, Goldman’s metric clocks in at a P/E of 21.1, compared with an average of 16.7 over the last 80 years.

Mr. Shiller says that his CAPE ratio, while high, isn’t yet in the danger zone. “It could be a bubble, but it might not be…it will take a little time to tell,” he said.

Mr. Shiller dismisses criticism of his index’s methodology given the current environment, saying that the measure hadn’t been distorted by previous major economic dislocations such as the Great Depression. Before the Great Depression, there was a pullback in profits during a smaller recession in 1921. But that didn’t push up the ratio, which didn’t rise above 20 for another seven years.

When it comes to the most recent period, according to Mr. Shiller’s data, profits were 40% higher for the 10 years ended June 2013 than the previous 10 years’ average—even with impact of the financial crisis.

Stocks won’t be in bubble territory until the metric climbs to 28.8, Mr. Shiller says. “That will be a milestone,” he said.