Yale professor Robert J. Shiller, the author of “Irrational Exuberance,” created one of the most useful and predictive measures of stock-market valuation: the cyclically-adjusted price-earnings ratio (CAPE).
As Professor Shiller explains in the TechTicker interview above, the CAPE mutes the impact of the business cycle by averaging 10 years of earnings. It thus provides a good picture of the market’s value regardless of where we are in the business cycle.
(Why is this important? Because profit margins are mean-reverting. In boom times, companies have high profit margins and big earnings. In busts, profit margins collapse and companies have small earnings. Taking a single-year P/E ratio can therefore provide a misleading picture of value: In booms, with high profit margins, stocks look cheaper than they really are. In busts, with low margins, stocks look more expensive than they are.)
As you can see in the chart below, Professor Shiller’s P/E has finally dropped below fair value for the first time in 15 years. The S&P 500 is down significantly since this chart was created, moreover, so the market’s cyclically adjusted PE is now under 14X (compared to a long-term average of about 15X).
So is Prof. Shiller going all-in? No. He’s waiting until the P/E drops below 10X, which it has done at major market lows in the past. That could happen either through an additional severe drop or a long period in which the market moves sideways and earnings grow again.
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