How High Is Too High?

9/8/2014


Among those arguing the U.S. stock market has entered a bubble, Yale professor Robert Shiller's cyclically adjusted price to earnings (CAPE) ratio is a favorite talking point. Popularized in Shiller's 2000 best-seller, Irrational Exuberance, the ratio compares the price of the S&P 500 Index to average inflation-adjusted earnings over the prior 10 years.

Today the CAPE ratio is near 26, a level surpassed only three times since 1880 — in the run-ups preceding the market downturns of 1929, 2000, and 2007. All else equal, the S&P 500 would need to drop 36% to return the CAPE ratio to its long-term norm of 16.6.

While all else is never equal, we also see specific reasons to question the CAPE ratio:

1880 is a long time ago. Using the norm of the past 50 years, 19.6, the CAPE ratio implies the S&P 500 is 25% overvalued. Using the norm since 1980, the S&P 500 is 18% overvalued.

Reported profits have been unusually volatile over the past 10 years, with huge write-offs in the financial sector in 2008 and 2009. If we use medians rather than averages to lessen the impact of extreme values, the CAPE ratio implies the S&P 500 is overvalued by 16% versus the norm since 1964 and 10% versus the norm since 1980.

Using trailing 12-month earnings, the S&P 500 is overvalued by 2% relative to the norm since 1964 and undervalued by 10% versus the norm since 1980. CAPE proponents argue that using 12-month earnings is unreliable, partly because they are so volatile and partly because investors tend to be most optimistic when corporate earnings are near a peak.

They make a good point. Still, it's worth noting that the CAPE model is calling the S&P 500 overvalued because its price is too high relative to 10-year average earnings — not because stock prices are too high relative to current earnings.

Inflation is low versus historical norms. CAPE does not take the current inflation rate into account when determining how much an investor should pay for a dollar of earnings; instead, it assumes the amount investors have paid since 1880 is correct.

When inflation is low, more of the stock market's dividend yield and earnings yield (earnings/price ratio) represent a real return. Real returns are what matter for wealth creation, so we looked at earnings yield minus the trailing inflation rate.

The earnings yield on 10-year average inflation-adjusted earnings is 3.8%, while the trailing inflation rate is 2.4%. The current spread of 1.4% is narrower than usual, but a mere 12% price decline in the S&P 500 Index would return the spread to the norm since 1964.

The CAPE ratio makes no adjustment for the fact that one of the stock market's primary rivals for investors' money (the bond market) is offering puny returns. Based on the spread between the earnings yield on 10-year inflation-adjusted earnings (3.8%) and the yield on 10-year Treasury bonds (2.4%), the S&P 500 is undervalued by 99% versus the norm since 1964. All else equal, T-bond yields above 4.3% would return the spread to the 50-year norm.

7 WAYS TO CALCULATE FAIR VALUE
CAPE
Ratio (P/E
On 10-Yr.
Avg. EPS)
CAPE Ratio
Based On
10-Year
Median EPS
Trailing
P/E Ratio
10-Year
EPS Yield
Minus
Trailing
Inflation
(%)
1-Year
EPS Yield
Minus
Trailing
Inflation
(%)
10-Year
EPS Yield
Minus
10-Year
T-Bond
Yield
(%)
1-Year
EPS Yield
Minus
10-Year
T-Bond
Yield
(%)
Recent
26.0
23.1
19.3
1.4
2.8
1.4
2.8
Average since 1880
16.6
16.5
15.9
4.5
4.8
2.4
2.7
Average since 1946
18.4
18.3
17.5
2.5
3.2
0.7
1.4
Average since 1964 
19.6
19.3
19.0
2.0
2.4
(0.5)
(0.1)
Average since 1980
21.3
20.9
21.2
2.2
2.5
(0.9)
(0.7)
Implied change in S&P 500 Index
On average since 1880
(36)
(29)
(18)
(44)
(28)
(21)
0
On average since 1946
(29)
(21)
(9)
(22)
(7)
23
37
On average since 1964
(25)
(16)
(2)
(12)
9
99
122
On average since 1980
(18)
(10)
10
(17)
6
149
192
Sources: Robert Shiller at www.econ.yale.edu and Standard & Poor's.

Conclusion

If you think earnings are headed lower because record-high profit margins are set to recede or because the world is coming apart at the seams, you can make a case that the S&P 500 is overvalued. But if you think profits are headed higher over the next 10 years, the bubble argument is hard to support — unless you expect inflation and interest rates to move sharply higher.

We'd like to see stocks move higher amid mild inflation numbers and a gradual rebound in bond yields. We'd also like to see the recent highs in the Dow Transports confirmed by a close in the Dow Industrials above 17,138.20. For now, our buy lists have 94% to 98% in stocks.


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