Have you ever tried to explain something difficult? A precursor to explaining the idea is first understanding the idea. Sometimes when we do not understand an issue, we take someone’s opinion as “fact.” Luckily, there are those that say “prove it.” So let’s walk through a difficult idea which should provide a better understanding and offer clarity for where the S&P 500 rests in “fair value” terms.
There are many “fair value” metrics that exist, but one of the most popular — and the subject of this article — is Professor Robert Shiller’s Cyclically Adjusted Price to Earnings ratio; straight from his site, shown below:
The blue line indicates the current level of (get ready) 10 years’ worth of trailing price-to-earnings ratio for the S&P 500. Got that? Professor Shiller takes an average of daily closes on a monthly basis for the S&P 500, then divides that number by 10 years’ worth of earnings. The red line is self-explanatory — the history of the 10-year.
What isn’t so obvious – what does 21.17 actually mean? Simply, Shiller uses the long-term average of 16.37 and determines that the S&P 500 is roughly 22% overvalued from the average of monthly closes (in this example, Shiller uses 1122.08 for September). The result? About 860 on the S&P.
But wait, Cyclically Adjusted implies something, doesn’t it? Very astute observation. Professor Shiller goes further into the nominal data and adjusts both price and earnings by the CPI from BLS. OK, once you stop laughing — the only reason I gather that he does it — is simply because that’s what an economist would do. Check out the difference from the nominal numbers (actual if you prefer) and Shiller’s CPI adjusted to make your own decision on the validity of the adjustment:
Looks the same to me, but then again, I am not an economist. Back in the REAL world (couldn’t resist), whether the S&P traded nominally at 1480 in Oct. 2000 or on a real (CPI adjustment) basis of 1880 doesn’t really matter. I can easily glean that the silly market was “overvalued” back then, similar to now.
Since I like to present information and let others decide how to decipher it, I created a table that answered many of the questions I possessed. Why 10 years (didn’t we have record earnings, mortgage securitizations, and explosive derivative growth)? Why average 10 years’ worth of trailing earnings — why not use a Monthly Price to Earnings? What about historical long-term earnings growth? To answer these questions, I turbocharged his data and generated the following chart:
Photo: Chris Tucker
With this table, one can see plainly where the valuation rests with the S&P 500 predicated on many variables. Pick your time frame, use CPI data, or combine everything. Using this table should help investors determine whether they should be trusting “What day is it – then buy” Bob Doll, or listening to Jeremy Grantham (he stated 900 as fair value on CNBC).
Before you load up on long puts or outright start shorting, please take heed of the improved Shiller and the nominal chart for comparison. Shown below is the example of simply placing data on a chart that is automatically calculated. Another improvement is simply using a logarithmic scale to show the differences over such a long time. Note that the market can stay overvalued for many years! But, it ALWAYS goes back to fair value at some point!
Photo: Chris Tucker
The chart simply shows that back in March ’09, the S&P reached “fair value.” And it also points out that we have rapidly reached overvalued again (anyone say “trillion”).
When comparing Shiller’s data and the nominal below, note that both are very close. Whether one chooses 903 or 892, both agree we are about 20% overvalued at this point.
Perhaps these charts supports the Hussmans, Rosenbergs, and Shillers of the econ world, but what really matters is what you do with the information. We will reach a fair value at some point either through earnings growth or by price decline.
Lastly, I created many combinations to capture a faster moving and more realistic value metric. I took pieces of data and combined them into a Combined Fair Market Value shown in the chart below.
The Combined Fair Market Value uses some sentiment (current index price), mixed with a little long term earnings growth, a pinch of averages and topped with some monthly PE data. Feel free to use whatever valuation metric suits your thought process.
The entire 15-page report is available for the low low price of — free. Just a click away!
The full report explains the mathematics, gives charts, links to source data, and provides methodology of calculations.
Hopefully this article helped explain something difficult. Now, when you read about Professor Shiller’s CAPE chart, you will understand the “magic” behind the numbers, or should I say behind the “CAPE.” Perhaps you will think of the Businessinsider.com article that provided an explanation. Meanwhile, for another time, be thinking about Tobins Q…