Are stocks overvalued?
Shiller PE. Source: Multipl.com
A cynic knows the price of everything and the value of nothing. That’s what I keep reminding myself when folks trot out historical PE charts like Shiller’s calculation, which averages corporate earnings over the last decade and then compares the stock market’s total market capitalization to that average. And by that measure, stocks are now valued at almost 30-times their decade-long average earnings.
That’s a figure that gives pause. It’s only exceeded by the levels of 1929 and 2000. Previous, lower peaks occurred in 1966 – just as inflation began to accelerate and valuations started to decline – and 1900, when …. Actually, it’s hard to say why valuations began to decline in 1900. There’s not a lot of published information from that period. In fact, it’s hard to say anything much about the economy of 120 years ago, except that it was booming.
And that’s one of my problems with Shiller’s chart. He aggregates a huge amount of data into a single chart which appears to tell a series of stories about fear, greed, valuation, excess, depression, recovery, and so on. The narrative is almost Shakespearian in its scope and depth. But the quality of the data on earnings and the market from the last 10 years is vastly different than the data from 100 or 50 or even 20 years ago. Company financial statements weren’t even audited until the ‘30s.
And why does Shiller use 10 years of earnings? Why not 20? Or 5? Presumably, a decade will average out the booms and busts of an economy. But it will also include – or exclude – random events in the rear-view mirror. It’s one reason why the market crash of 1987 barely shows as a blip on Shiller’s graph. Earnings had been growing in nominal terms for more than a decade, overshadowing the market’s extended valuation in the Spring and Summer of 1987.
Valuation measures like Shiller’s PE can be useful for planning purposes, but they make poor market-timing indicators. So don’t panic over references to 1999 or 1929. Those comparisons are often used to make headlines and generate clicks. It’s unlikely, however, that the author knows anything about what comprised earnings back then. And earnings – their composition, their source, and their quality – are at least half of any PE ratio.
Douglas R. Tengdin, CFA