IS THE MARKET CHEAP?
According to the Shiller 10 year PE ratio the stock market is now trading at a hefty 18 PE. This is just slightly higher than the historical norm. Image 1 clearly shows that the market is neither extraordinarily expensive nor extraordinarily cheap, despite what some noted bears say. What is more interesting in this data is not the exact price, but the action surrounding overshoots and undershoots. In each of the instances where the S&P 500 approached an extreme overshoot of 25, the market undershot over the course of the following 5 years and always approached a PE between 5-10. Like Grantham, I am a firm believer in mean reversion and the idea that the mean tends to be overshot.
Chart 2 shows the extreme moves in terms of % above/below the long-term average. Although the market is not overly expensive or inexpensive it is interesting to note that we have not overshot to the downside despite the largest overshoot in the history of the market. This would lead one to believe that there is much more work to be done on the downside as PE’s contract and the market digests its excesses of the last decade.
Shiller’s spreadsheet always seems to be missing data. The earnings cells for July and August are blank (cell 1671-J and 1672-J), yet there are used in the PE calculation. If you fill these in with a value of 7.47 (value from June in cell 1670-J) that pushes the actual 10 year PE over 19. Still, as you said, not too extreme, unless we see the usual mean reversion on the downside…
The thing is the timeframe it takes to go to trough … many years to decades. And it seems we have no memory or patience for that … bulls have no memory, and bears have no patience, want to rip the bandaid off right away … and everyone gets whipsawed in the interim. Good fun for all.
This is a goood post. I was studying this last night on the dshort.com website.
The downside if we get it in the single digits per historical norm can take as long as 19 year or as short as 3 years.
Bottom line is that if historical norms are going to play out then we will have to go below 600 on SPX to ge into the high single digits.
This doesn’t mean that we cannot go higher because we can and still be in the historical norm because according to dshort.com we are in the 9th year of this cycle.
>>Bottom line is that if historical norms are going to play out then we will have to go below 600 on SPX to ge into the high single digits.
Not true if inflation catches hold a la Faber in next [decade] …
“The PEG ratio of 1 is sometimes said to represent a fair trade-off between the values of cost and the values of growth, indicating that a stock is reasonably valued given the expected growth. A crude analysis suggests that companies with PEG values between 0 to 1 may provide higher returns”
http://en.wikipedia.org/wiki/PEG_ratio
today:
fdx – peg=2.75
xom – peg=2.15
ge – peg=2.36
ba – peg=2.14
cat – peg=4.04
amzn -peg=1.81
aapl -peg=1.59
For us to undershoot and bottom like we have at every other significant market bottom over the last 100 years (save for 2000-03 when cheap money propelled us out of the mess) we’re looking at an S&P range of 350-450. But maybe this time is different…
We can also undershoot by raising E while keeping P more or less constant. Granted, I don’t think that is what will largely be responsible for undershooting in the short term, since it will be very hard for most companies (except investment banks) to raise revenue (and profit) given the macro backdrop of the US economy (large unemployment, large debt overhang).
This uses a 10 year trailing average for earnings, so for the E to go up we would need to be reporting earnings in the coming months that are higher than the monthly figures that they are replacing from 10 years prior. That is highly unlikely.
Would a much higher average P/E ratio be warranted after the US got off the gold standard?