More on Stock Market Valuation – The Shiller PE Ratio / CAPE Ratio
I’ve been covering the recent debate about how high stock market valuations are with special attention to the Shiller P-E ratio, also known as the CAPE (cyclically-adjusted price-earnings ratio). The ratio uses 10-year inflation-adjusted earnings instead of just one year’s earnings to value the stock market. Advocates believe that historically it’s been very good at identifying extreme tops and bottoms in U.S. stock indexes. But the measure hasn’t worked too well since 2000, according to others.
Here are two more entries into the debate. This article takes apart the CAPE, mostly using arguments available elsewhere. Its main point is that the economy, earnings, and other things are different now, so the history of CAPE isn’t relevant today. This is a more thoughtful and extended discussion apparently with some original research. It concludes that even if adjustments are made for the alleged flaws of CAPE, the adjusted number isn’t dramatically different from the traditional number. Its main points are that most measures indicate U.S. stocks are expensive today but not by a large margin and that most people use too long of a measurement period. Seven years appears to be the right period to determine a stock index’s valuation level.
Recessions bias CAPE up. Bubbles bias CAPE down. People often find a way to justify their market stance. I’ve humorously received both of these critcisms from market bulls and bears! Here is a sample from one of my friends “We don’t like using the CAPE because it includes 2008-2009 earnings which distorts the PE since earnings are too low.” My response to this is, well, according to your logic, do you also exclude 1999 and 2007 as being abnormally high? And then, if you make the adjustments, does it even matter? This is a similar, but slightly different argument (one off recessions) than the prior one (an accounting inconsistency).
Below we adjust the earnings series from Shiller to pretend like 2008/2009 never really happened. We adjusted the earnings series so that earnings didn’t decline in 2008 and 2009 (they had already started to decline a bit in 2007). The second chart is the adjusted CAPE series. If you adjust the data it moves the CAPE from approximately 25 to 23. There is basically no difference and stocks are still expensive, but not terribly so due to the mild inflation sweet spot we are in.
