Dec 15

S&P500 Appears Overvalued

The Shiller PE ratio has been a pretty useful guide over the years as to whether the US sharemarket in general is over or undervalued. The above chart shows this statistic to the end of November  where it has the value of 21.8. Compared to its historic average (16.4) the S&P500 is around 33% overvalued and compared to the 40 year average (19.2) is around 14% overvalued. There could be many arguments supporting the current price, such as the Fed’s quantitative easing part 2 (QE2)channelling significant cash into the market and the continuation of record low interest rates, weak US Dollar inviting foreign capital, etc., but that does not provide sufficient reason to suggest the S&P500 is good value.

The US economy will not be bouncing towards massive growth, it will be a slow and painful journey; the reason why QE2 exists is that deflation is the threat, not inflation as the consumer is struggling, the US Housing market and unemployment levels are not going to improve dramatically for quite some time. So buying a market with a high PE with the high potential of slow growth is fraught with danger.

Hopefully I’m wrong as many superannuation funds depend on a strong US sharemarket but personally I’m underweight this part of the global sharemarket as the downside risks appear high.

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  1. Afundie

    Taken from an article in Seeking Alpha written sometime ago but criticism of the Shiller PE is valid today as well:

    “The big problem with the Shiller PE becomes apparent once you look “under the hood,” at the data. The market’s current PE of 20, based on Shiller’s data, doesn’t make much sense once you examine the actual stocks involved.

    Take Apple (AAPL), for instance. The cyclically adjusted earnings used for the CAPE analysis are $2.38/share, compared to the $9/share they earned in 2009 and the $11.64/share expected this year. It’s certainly legitimate to argue that margins and earnings will “revert” to a lower mean, but putting a 15 PE on Apple’s cyclically adjusted earnings would necessitate a stock price of $36, ie 84% below where the stock currently trades. That would be slightly above the $27 in cash per share on Apple’s balance sheet.

    Another example of the problem with using cyclically adjusted PE ratios is Citigroup (C), whose 10 year average earnings per share is $1.62. If you want to value the company based on that number, be my guest. But be aware that in 2011 Citigroup is expected to earn 34 cents. Paying 12 times the 10 year earnings figure would put the stock at $20, or 400% above current levels.
    The Shiller PE is extremely useful, but it shouldn’t be an excuse for people to avoid digging into the individual stocks making up the market. Instead of the S&P 500 trading at 20 times earnings, I find it closer to 11-15 times earnings based upon 2009-2011 earning levels. It would be even lower if it were not for Berkshire’s (BRK.A) high PE, which is misleading due to the way its ownership positions are valued.

    Shiller’s CAPE will definitely encourage buying the market at cheap valuations, but it can also make the market look severely overvalued … unless you think Apple is worth one times 2009 earnings, after pulling out their $27 in cash per share.”

  2. BB

    There are plenty of valid criticisms of the shiller ratio, as with any tool or collection of tools used to value markets. But as with any theory you need to keep in mind its intended context.

    1. As far as I can recall Shiller PE’s were always intended as measure for broader markets and not individual stocks, specifically for some of the reasons outlined above. The rational being that there will always be “apples” in a dynamic market, but there will always be dogs also, so on average these issues will balance out when considering a broad index with a wide and deep collection of industries.

    2. The measurement of broader markets is there to provide a useful check of overall market valuations against historical norms, a check on “greed and fear” if you will. Investors should know all too well that periods of high market valuations have historically given way to poor future returns. Even staunch value investors know that individual stock selection is unlikely to protect capital during broad market falls.

    3. Shiller himself stated that such ratios are not to be used for short term market timing. And if one believed in the context of the data they would also understand that periods of over valuation can last for many years. I can’t recall the piece but Shillers suggestion was that investors are best to deploy their capital in all conditions where valuations are low or fair, as the occurrence of future positive (long term) returns from these levels far outstrips those at elevated PE’s. Furthermore waiting for periods of large undervaluation would likely see an investor out of the market for long periods.

    4. On the note of valid criticisms, considering that this is a PE measure I would submit that any ratios that require some form of “normalisation” for the ratio inputs are far superior to the traditional methods of equity sales, sorry valuation. PE’s based on trailing or future earnings estimates are of far more use to brokers than investors.
    There is some interesting academic work out there that breaks down long term historical return periods into PE quartiles. The exact numbers are debatable but the data provides an excellent insight into subsequent 5 or 10 year returns based on various starting period CAPE ratios. In my view the most important part of this argument is the undeniable evidence backing the claim that starting valuations matter! And that a fairly simple analysis like this (along with the assessment of other data, like earnings levels, profit margins, credit spread etc) is probably enough to give the average buy and hope investor a very good indication as the probability of achieving the allusive “average long term market return”

    SIDE NOTE: Where does your average investor/advisor get raw ASX data to conduct such research?? Its seems a Bloomberg login (at some stupid cost) is the only hope here.

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