Shiller's Market Forecast Underscores Need for Caution

With the S&P 500 Index after Monday’s surge again slightly above the “neckline” (of the head-and-shoulders formation referred in a post last week), I will be monitoring things very closely over the next day or two to see if the impressive bounce was just a one-day wonder or something more enduring.

Meanwhile, the S&P 500 is now fairly valued on a long-term cyclically adjusted P/E (CAPE) basis, according to Robert Shiller (as reported by Yahoo Finance, Tech Ticker). Shiller is economics professor at Yale and author of, among others, Animal Spirits, Subprime Solution and Irrational Exuberance.

In order not to work with notoriously unreliable forward-looking earnings estimates, I have always preferred using Shiller’s CAPE methodology, or normalised earnings, as they average ten years of earnings. This measure provides a good picture of the market’s value regardless of where we are in the business cycle. I have therefore been updating a CAPE chart for a number of years. On this basis, the multiple increased to 15.8 during the March-May rally, representing “neutral” value when compared to a long-term average of 16.3.

Click to enlarge:

According to Yahoo Finance, Tech Ticker, Shiller is skeptical of the “green shoots” viewpoint and is of the opinion that it would take a considerable period of time for the economy to return to normal growth. Although the stock market’s neutral valuation implies a long-term average return of 7%, he is not forecasting that outcome due to the “precarious state” of the economy that could stumble anew and cause stocks to “go down a lot”.

As mentioned in my “Words from the Wise” post on Sunday, the stock market technicals undoubtedly look ugly and investors will now focus on the second-quarter earnings reports as a test of whether stock prices have run away from fundamental reality. While investors wait for Mr. Market to show his hand, a cautious approach is warranted, but that should not preclude one from finding stocks that look cheap.

Click on the image below to view Aaron Task’s interview with the famed professor.

Source: Yahoo Finance, Tech Ticker, July 10, 2009.

Comments

[CautiousInvestor]

Prieur, thanks for the link.

After watching the interview, I leave with a feeling Scheller is very concerned abou the future and selects such words as perilous to describe an economy gripped by chaos. He sees much more downside risk and urges diversification as the recovery will be slow and take years to come.

2009 Jul 14 07:48 AM

[John Galt]

"I have always preferred using Shiller’s CAPE methodology, or normalised earnings, as they average ten years of earnings"

but to play devils advocate, what if the last 10 years were excessive? If you averaged the earnings of the roaring 1920's, do you think that would be good data or bad data? How about the last 10 years we had, do you think they are indicitive of the next 10 years? Internet boom/internet bust, multi property real estate tycoon/ few hundred grand under water...

The Fed induced credit bubble burst, now for the hang over.

2009 Jul 14 08:40 AM

[Henry Buttal]

Prieur,

Excellent observations as always. I share Shiller's concerns about the near term.

John Galt, I think Shiller, more than almost any other economist, recognizes investment return averages are baselines, and that swings around the baselines are part of the equation. I always find his observations more insightful and honest than Glubman.

2009 Jul 14 08:52 AM

[Fighting Yoda]

Even though things tend to move towards the average - I do not believe in 10 year average or some such - there is particular logical or historical basis. Nothing has been shown that suggests last 10 year's average would be the 11th year's earnings.

In any case I am bearish overall, expect earnings and markets to keep going down - double dip, downwards staircase.

2009 Jul 14 11:43 AM