The Wall Street Journal reports that an examination of Yale University economics professor Robert Shiller’s valuation metric may be “sending a false signal” by warning that the stock market may be “dangerously expensive.”
Shiller’s measure, created with Harvard University economist John Campbell in the 1990s, is called the “cyclically adjusted price-earnings,” or CAPE ratio. The index, sometimes called the “Shiller P/E,” essentially divides share prices by the average of 10 years' earnings adjusted for inflation. It compensates for extreme volatility by valuing share prices based on 10 years of earnings, rather than one year.
However, the Nobel Prize winner’s measure “looks terrifying right now.” Every time it has gotten this high, markets crashed, the Journal reported.
The CAPE is now at 27. “That is about where it was in 2007, before the financial crisis, and it is well above its 50-year average of 20. The only times the CAPE has been higher were during the 2000 bubble and bust, and just prior to the 1929 crash, according the data compiled by Shiller,” the Journal reported.
Wharton professor Jeremy Siegel told the Journal that accounting-rule changes have pushed the recent earnings lower, and that has made the CAPE artificially high relative to its history, the Journal reported.
Shiller uses S&P 500 earnings under generally accepted accounting principles, or GAAP, which avoids many of the tricks that companies use to embellish results. However, there have been countless revisions to the rules. Siegel told the Journal that the changes lowered GAAP earnings, even though there were no changes in the underlying businesses.
“An alternative CAPE, constructed by The Wall Street Journal, uses the same methodology as Shiller, but relies on a more consistent earnings measure: The Commerce Department’s quarterly data on total U.S. after-tax corporate profits. Then for prices, it uses Federal Reserve data on the total value of the U.S. stocks, rather than the value of the S&P 500,” the Journal explained.
The Journal’s metric shows that stocks look much cheaper than Shiller’s formula.
Shiller agrees that the CAPE can’t be used as an actual market-timing tool. Rather, he thinks that investors should tilt their portfolios away from individual stocks that have high CAPEs. He also doesn’t plan to change his formula.
To be sure, other respected economic gurus say there is a way to use the Shiller index.
"From one year to the next, earnings can vary widely," says Newsmax Finance Insider John Mauldin, chairman of Dallas-based research firm Mauldin Economics. "The reason you use the Shiller ratio is to smooth out those earnings gaps, and get better historical context," he explained to Reuters.
For those fretting about a lofty Shiller P/E, Mauldin suggests a prudent course of action: Keeping some powder dry, in cash.
"The worst thing investors can do is think that they have to put all their money to work, right away," he says. "No, you don't. If valuations like the Shiller P/E seem high, just wait, and they will come back."
Shiller himself has also advised stashing away cash: "You have to save more; unless you have some special idea, realistically you are not going to get the same returns," Shiller told CNBC.
"Saving, as Shiller recommends, is probably your best hedge," James Saft, a Reuters columnist, explained. "There, in a nutshell, is the current situation: bet on your ability to find gold among the dross or tighten your belt.
Others advise that a savvy investor, as with all investment decisions, proceed with caution and consult a professional before making any life-changing decisions.
"It is one way of looking at earnings, but it is not the only one," says David Bianco, chief U.S. equity strategist for Deutsche Bank.
The Shiller P/E "has consistently signaled an overvalued market, and if you let it drive your decisions, you likely would have been out of stocks entirely."
(Newsmax wire services contributed to this report).
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