This article is in response to an article recently published online that argues that the US stock market is overvalued based on the Shiller CAPE ratio.
The article states, "Shiller has plotted CAPE going back to 1881 and notes (with some alarm) it has only been higher than current levels three times: In 1929, 2000 and 2007."
For anybody not familiar with the CAPE ratio it refers to the cyclically adjusted price earnings ratio. It is a price earnings ratio that is based on average inflation-adjusted earnings from the previous ten years. It has become popular among those in the media touting it as a way to predict market tops and bottoms. We argue that one should not only examine the P/E alone whether it is a current P/E, forward P/E, or CAPE. However, one should examine the P/E relative to the interest rate environment. For example, if interest rates are low the expectations are that companies and people will borrow now leading to investments and higher earnings in the future. Therefore, we should witness a high P/E where future earnings are expected to increase. In a high interest rate environment investment and earnings should be expected to decline and we should experience lower historical P/E ratios. In this article we compare the current interest rate to the inverse of the Shiller CAPE ratio. However, first let us examine the chart of the Shiller CAPE in 1929, 2000, 2007, and 2014.Click to enlarge
The above chart displays that the 2007 high of the Shiller CAPE is very close to the current CAPE today.
Now let us examine the inverse of the Shiller CAPE and subtract it from the current ten year Treasury yield. This model is called the Fed model, however, instead of using the current earnings yield we are using the inverse of the Shiller CAPE ratio. The purpose of this exercise is to take into account current interests rates and compare the Fed model among the same periods.
In 1929, 2000, and 2007 the Fed model using the inverse of the CAPE ratio was negative. This means that Treasury yields were higher than the cyclically adjusted price earnings. In other words, one can earn a higher yield investing in risk free Treasuries than the stock market. This does not make sense given the risk associated with stocks. Prices had to decrease in order for the cyclically adjust earnings yield to increase. However, in 2014 the cyclically adjusted earnings yield is positive at close to one percent. I argue that as long as interest stay low and assuming a continued CAPE ratio of 25, the US stock market is appropriately valued.
As soon as interest rates increase significantly assuming the current CAPE remains the same, I would then warrant a discussion on over valuation. That means the ten year Treasury yield would have to increase to 4% from the current 2.34%.
I suggest to remain in the US stock market using SPY until the cyclically adjusted earnings yield becomes lower than the current ten year Treasury yield.
Disclosure: The author is long SPY. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.