Shiller Metric Carries Warning for Stocks
April 4, 2014 Leave a comment
Shiller Metric Carries Warning for Stocks
SPENCER JAKAB
March 23, 2014 12:27 p.m. ET
Asked to define a bubble, some Wall Street wags say it is a bull market that an investor has missed.
But with the period between earnings seasons now under way and the S&P 500 back near its record high, investors may turn more attention to the stock market’s overall health rather than just that of its components.
Many have quibbled with Yale professor Robert Shiller’s use of a cyclically adjusted price/earnings ratio. Few can fault his timing in calling out perhaps the greatest stock mania of all time with the publication of “Irrational Exuberance” in the spring of 2000, though.
Mr. Shiller’s technique uses a decade of inflation-adjusted earnings to derive a P/E ratio. That is in contrast to the more common practice of basing it on a year of analyst forecasts. By his measure, stocks now trade at 25.5 times earnings, 54% above the average going back to 1881.
Peaks in this measure have come before downturns in 1929, 2000 and 2007, but also many times in between. The Shiller P/E is thus no market-timing tool. Still, a look at the big picture should give pause.
The ratio is now in the top tenth of historical observations. Previously, at such levels, real compound annual changes in the S&P 500 have averaged negative 1.4% over the next 10 years. At the other extreme, the change has been a positive 6.4% when P/E ratios were in the cheapest tenth of observations.
Until recently, critics complained that the 10-year sweep of the Shiller P/E covered two market washouts, early and late last decade, which was unusual. That argument has expired now. But some still insist write-downs during the financial crisis skewed even a 10-year average P/E.
Furthermore, some Wall Street strategists argue that historically high profit margins at the moment are sustainable. Don’t get complacent, though. Since profit margins also were inflated during the housing boom, the Shiller P/E actually might be understated.
Perhaps investment firms that were caught out by recent debacles are right this time and not the man who identified the housing and tech bubbles. Not just 14 but 140 years of market history say otherwise.
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