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As our latest weekly Sentiment Survey results indicate, bearish sentiment continues to fester among individual investors. It seems that every time investors see a glimmer of hope for the economy, something spooks the market - such as the report issued last Friday by the Department of Labor indicating that no net new jobs were added in August. Investors keep waiting for our government to take some meaningful action. Meanwhile, low investor confidence in the economy keeps the markets down. The markets fell again today when Fed Chairman Ben Bernanke failed to identify any new plans to stimulate U.S. economic growth.

During times of uncertainty, there is a tendency to either freeze or panic and let our emotions get the best of us. A historical perspective can help put the current market conditions into the proper context and help you take actions that are guided by your head, not your emotions.

In the September 2011 AAII Journal article "A Cautionary Note About Robert Shiller’s CAPE," Stephen Wilcox examines the construction of Shiller’s cyclically adjusted price-earnings ratio (CAPE) in order to determine whether its current bearish reading is applicable in today’s marketplace.

In the late 1990s, Yale professor Robert Shiller examined the usefulness of price-earnings ratios (price divided by earnings per share) as predictors of future stock market performance. He observed that, while it was difficult to predict stock market performance in the near term (one-year horizon), there was a strong relationship between the price-earnings ratio and the long-term market return (10-year horizon). Shiller used the average real (inflation-adjusted) earnings over the past 10 years in his analysis. He found that this smoothed the extremes of the ratio and improved its long-term stock market return forecasting ability.

In his AAII Journal article, Wilcox argues that Shiller’s CAPE ratio provides an overly bearish view of the stock market today and that the traditional price-earnings ratio based on either reported earnings or operating earnings is a better measure of the worth of U.S. equities as of July 2011.

AAII members can download our Historical Market Data spreadsheet from the Download Library. This spreadsheet allows for historical examination of the S&P price-earning ratio and dividend yield and how they relate to current valuation levels. The price-earnings ratio provides valuable insight into market levels. In theory, the market is fairly valued when stock prices reflect reasonable expectations regarding future earnings growth. The price-earnings ratio is primarily driven by stock prices, although earnings also respond to changing business conditions.

Since 1960, the price-earnings ratio for the S&P 500 has averaged 16.8, with a high value of 35.4 in April of 1999 and a low value of 6.9 observed during March of 1980. When greater risk and uncertainty in company and market prospects are perceived, price-earnings ratios contract, and consequently, valuations decline as investors are only willing to pay a smaller amount for a given level of earnings. Similarly, when less risk and uncertainty is perceived, price-earnings ratios rise and investors are willing to pay a much larger amount for a given level of earnings. You can use history as a guide, but make sure you temper it with an evaluation of the current environment.

This Week's Gratis Tip

The price-earnings ratio contains a wealth of information about the market's expectations for earnings growth. However, if you look through any investment information resource commonly used by individual investors, you'll see what appears to be endless variations on a theme. Will the Real P/E Please Stand Up? sorts through the different ways price-earnings ratios are quoted and shows you how each different price-earnings ratio technique can be applied and interpreted.

The Week Ahead

We are in a quiet period for earnings announcements, but a few companies will release earnings next week that may shed some light on consumer spending. Best Buy (NYSE:BBY) and Cracker Barrel Old Country Store (NASDAQ:CBRL) report earnings on Tuesday. Pier 1 Imports (NYSE:PIR) and Research in Motion (RIMM) report on Thursday.

On the economic reporting front, August producer prices (PPI) will be reported on Wednesday, followed August consumer prices on Thursday.

Source: Putting The Current Market Into Historical Context