Seeking Alpha

I think Robert Shiller is hands down one of the best academics around. There is an old saying of, “Those who can’t do, teach.’ In the case of Robert Shiller nothing could be further from the truth. He called the stock market bubble and real estate bubble with almost pinpoint precision. Not only is he one of the best academics around, he is one of the best investment analysts around.

Despite my praises for Mr. Shiller, I find the usefulness of his P/E ratio, which uses 10 year average earnings, to be extremely lacking. I think there is a significant flaw in using average 10 year average earnings as the denominator in the P/E ratio. To give you an idea, I took the P/E ratio at the end of each calendar year from 1899 to 2000 and ran a simple regression of the P/E against subsequent 10 year returns. I got an r-squared of 1%. (100% would be perfect correlation.) What this means is that 1% of returns over a 10 year period is a function of stock market valuation. My opinion is that given the low r-squared, using 10 years average earnings is the improper time period to measure earnings.

I decided to take the same time period but for earnings to use the highest level of earnings in the last 5 years. (This removes the impact of the market looking artificially overvalued during times of recession.) The regression had an r-squared of 43%. Hence, 43% of a market’s return was related to valuation. In ‘quant land’, this is a fairly high number.

Below is a table that compares 10 year returns broken out into valuation quintiles under both methodologies. You will notice if you broke up the year-end valuation numbers into quintiles, you can see a higher correlation between valuation and returns when using the 5 year peak earnings in the denominator of the P/E ratio.

P/E Valuation vs. Subsequent 10 Year Total Stock Market Return

 Return Using Return Using 10 Year Average EPS 5 Yr. Peak EPS Valuation in P/E Ratio in P/E Ratio 1st Quintile 10.68% 13.41% 2nd Quintile 13.14% 10.99% 3rd Quintile 10.61% 9.61% 4th Quintile 8.20% 9.19% 5th Quintile 5.58% 5.66% R-Squared 1% 43% Current P/E 22.0 12.7 Current Valuation Percentile 71% 49%

The last point I will make is that the current valuation of the market, as measured by the 10 year average P/E ratio, is in the top 71% of history. Conversely, if you use peak 5 year earnings, we are at 49%, or the mid-point of the historical range. My only caveat with using 5 year peak earnings is that it may be awhile before we get back to this level due to the once in a lifetime bubble in the financial sector. However, based on the valuation (P/E) of brand name non-financial companies such as Kimberly Clark (KMB) (14.0), Johnson & Johnson (JNJ) (12.2), Wal-Mart (WMT) (13.2), Becton Dickinson (BDX) (13.5) and Microsoft (MSFT) (13.0), I think the market is attractively valued. It is certainly more attractively valued than the P/E based on 10 year average earnings would imply.

For reference purposes, below is a chart showing the P/E ratio, based on 5 year peak EPS vs. the S&P 500 Index since 1900 through July 12, 2010.

click to enlarge

Disclosure: The author and his clients are long Kimberly Clark, Johnson & Johnson, Wal-Mart, Microsoft and Becton Dickinson.