Is The Market Overvalued?

 |  Includes: DIA, QQQ, SPY
by: Zacks Investment Research

Yale Professor Robert Shiller's price/earnings ratio is getting fresh press these days. U.S. stock markets (SPY, QQQ, DIA) have all hit multi-year highs. They recorded their best quarter in 15 years. The question the stock market highs raise is: Is this market overvalued?

Robert Shiller's valuation ratio provides us one avenue to address the current valuation concern. His P/E ratio is based on average inflation-adjusted earnings from the previous 10 years. This P/E ratio gives investors a view on stock market valuation over a full business cycle, smoothing out both recessions and booms in corporate earnings. This P/E ratio is also known as the cyclically adjusted P/E ratio (the CAPE ratio), the Shiller P/E Ratio, or the P/E 10.

How to Compute Shiller’s CAPE

  1. Look at yearly earnings on the S&P 500 for each of the past 10 years.
  2. Adjust earnings for inflation, using the CPI. In other words, quote each earnings figure in 2012 dollars.
  3. Average these values. In other words, add them up and divide by 10. This gives us "e10."
  4. Then, take the current price of the S&P 500 and divide by e10.

The chart below shows Shiller's CAPE ratio over the last 160 years of U.S. stock market data. Bob Shiller likes to look over the long sweep of history. Interestingly, this chart included long-term interest rate data from fixed income markets over the same 160-year period. That is what attracted me.

What History Shows

Long-term interest rates hit a major high in 1921. At the same time, the stock market Shiller valuation hit a major low. Then, long-term interest rates declined. As rates declined, stock market Shiller valuations rushed up into the Crash of 1929. Rates continued their decline until 1940.

When interest rates reversed upward after WWII, the long-term valuation of the stock market went with it. Until 1966. Then, the Vietnam War and Arab Oil Embargo squelched a 25-year stock market valuation rally, and gave the U.S. economy a battle with high consumer price inflation.

From 1940 to 1980, forty years in a rising rate formation materializes. A historic high in long-term U.S. interest rates is placed in 1981. Again, once interest rates hit a major high in 1981, the U.S. stock market hit a major Shiller valuation low. This may be the key insight of this valuation model: History shows us that Shiller CAPE valuation lows in stock markets tie directly into the major highs in long-term interest rates. Stock market valuation bulls ran for the next 20 years, all the way to a peak in the Shiller P/E ratio in 2000.

What About Today?

Long-term interest rates have been declining since 1981. This long run down in rates is now over 30 years old. Pundits keep calling for a turn upward in long-term rates. It has not materialized.

Lesson No. 1

The Fed is working overtime to manage down the long-term 10-year U.S. Treasury rate to 2.0%. This chart tells us one reason why. Keeping long-term interest rates near historic lows makes stock valuations relatively more attractive. A risk trade is made better. The long sweep of history confirms the simple logic in that policy. If long-term rates rise, history also says that is not the end of the bull market in terms of Shiller valuations. Stock valuations can keep going up for years, as long as the rise in long-term rates is modest and steady. However, if inflation blasts upward like in the late 1970s to early 1980s, as some predict, this model says the results for stocks would not be so simple. It would be disastrous.

Lesson No. 2

Today's stock market trades at 23.40 on the Shiller CAPE. That looks high in historic terms. This is Bob Shiller’s big point. However, remember the past 10 years of earnings data include the 2008 and 2009 years. There was a deep, leveraged collapse in earnings here. Take those earnings years out, and the current valuation alarm falls away. The lesson here is to look out for a major market event to derail market matters, like an oil embargo, or an overleveraged housing crash. Something in broader Europe looks appropriate today. A future valuation trip up, with the Shiller CAPE ratio rising above 30, would be the zone for concern. That is a +30% valuation-only move from here.

Lesson No. 3

For a competing valuation perspective, consider this. Trailing 12-month P/E ratios for the S&P 500 index show us a 15 valuation. The forward 12-month S&P 500 valuation is around 14.5 at the moment. The former is valued in line with its historic 160-year norm. The latter is slightly undervalued. The final lesson is this. The trailing-forward 12-month P/E gap is constructive -- as long as the +3% to +5% earnings growth this gap predicts materializes this year. As long as we stay away from valuation extremes, we are good to go.