Is Robert Shiller Right That The Market's Overvalued?

Includes: IUSV, IWV, SPY
by: Todd Feldman

Robert Shiller is known for his P/E model that adjusts earnings cyclically over 10 years. The Shiller P/E as of September is 19.84. The long-term average going back to 1881 is 16.42. Since the current cyclically adjusted price-earnings ratio (CAPE) is above its long-term average he suggests the US stock market is overvalued. However, there is a problem with comparing the current CAPE to its long-term average because it ignores the current market environment. Investors have to do something with their money. The real question is how does the US stock market compare with other investment alternatives, namely the bond market. Which market is a better play? Therefore, we decided to examine the difference between the earnings yield based on Shiller's CAPE and the long-term interest rate.

Below is a figure that charts the spread since Shiller from 1881 to 2011.
Figure 1: CAPE Earnings Yield minus Yield on 20 Year Treasury

(Click chart to enlarge)
Click to enlarge

It is important to notice the trend that we are currently in as opposed to single data points. At the beginning of 1950 the spread declined until 1968. It then increased until 1978. From 1978 the spread was volatile with a slight downward trend until 1982. The spread became less volatile trending down until 2000. From 2000 onward the trend was up. Prior to 1950 the spread does not appear to have a trend similar to the post 1950 period and therefore it is hard to compare today with prior to 1950. The question then becomes where are we today based on this analysis? It appears we have gone through the 1968 -1978 period and we are currently in 1978. At the beginning of 1978 the spread declined as the stock market improved. However, it fell again in 1980. As of September 2011, the spread between the earnings yield and long-term Treasuries is 3.20%. The spread in November of 2008 was 3.03%. Today we are at a level similar to the post Lehman bankruptcy as of 11/2008. This does not sound like the US stock market is overvalued.

What does this analysis conclude? First it does not conclude that the US stock market is overvalued. Just the opposite. It concludes that the US stock market is a good deal compared with Treasury bonds. This does not mean the US stock market can go lower of course. However, we do not agree with Shiller that today's valuations are still overvalued. We believe one should hold onto their US stock market ETFs. Based on the current environment we do not see any good returns for the next 3-5 years. However, we do not see a financial crisis as of right now.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.