The Shiller P/E Is Misleading? In A Word, No!

Summary

• A writer I recently read claimed the Shiller P/E misleads because of the impact the Great Recession had on earnings.
• That's a historically myopic and wrong assessment.
• 1929 and 2000, the last times the Shiller P/E peaked at insane levels, had their own pre-peak weaknesses that impacted the ratio, and still the market plunged.
• And the writer's claim that low-interest rates today deserve a higher multiple because of earnings growth is blind to the impact that rising rates historically have had on S&P valuations.

I read a fascinating article this week – fascinating in its historical myopia.

The writer tried to make the argument that the Shiller P/E ratio is, effectively, a lie. His claim was that the P/E’s current reading – now approaching a mind-numbingly excessive 30 – should be discounted because the Great Recession of a decade ago is warping the E in the P/E.

He has a point.

It’s just the wrong point, buttressed by a wrong analysis of the data – which I will get to in a just a moment.

To be perfectly clear: The Shiller P/E is screaming a warning to anyone who will listen. To be sure, it’s hard to hear that warning over the drone of incessant upbeat commentary everywhere … or, maybe, because too much of Wall Street ambles around these days with fingers in ears, refusing to listen to news it doesn’t want to acknowledge.

Alternative facts! Alternative facts!

That’s what the Street wants. Anything to keep the party amped up.

Personally, I’ve begun paring my holdings in the market, taking profits in certain positions and putting stop-loss orders in place on others … just in case the cheerleaders are wrong. And I continue to recommend every sane investor do the same. You don’t have to sell. If you think the market is going higher, great! Just make sure you have trailing stop losses in place to protect your downside in the event the cheerleaders aren’t right in their exuberance but, instead, are just hopped up on ecstasy.

Now, onto the debunking …

First, let’s set the stage for our play. The Shiller P/E has peaked at extreme levels on three occasions:

At just over 27 in 1929, as the Roaring 20s ended with the beginning of the Great Depression; at just under 44 in 2000, as the technology bubble burst; and today, at just under 30, after a decade of central-banking manipulation to reflate asset prices after the Global Financial Crisis/Great Recession.

The writer claims that today’s Shiller P/E is misleading because of the Great Recession of 2007 - 2009, which led to “very low average earnings,” he notes. He also claims that Wall Street profits are more valuable in an era of low interest rates, thus giving investors reason to bid stock prices higher.

And to those points, he is right.

But, as they say, a stopped watch is right twice a day, too … but what are we to make of it the rest of the time?

By which I mean in this case: What about the past?

Ah, therein lies our rub!

The writer claims contemporary times are unique because the S&P’s earnings prior to previous Shiller P/E peaks were not as harmed by economic issues as were the earnings that affect today’s Shiller reading. He claims, for instance, that “In 1929, the 10-year period was mostly the Roaring 20s, an economic boom time with high growth and high earnings.”

At this point we need to insert the Price Is Right whomp-whomp-whuuuun “sorry you lose but thanks for playing” buzzer. Our writer friend is painfully wrong.

Corporate earnings going into the Roaring 20s had been destroyed by years of war, and the roar of the 20s was the unleashing of pent-up demand of the early iteration of what would ultimately morph into America’s middle class.

From 1916 to 1921, S&P earnings plunged from a peak of $32.28 per share to $4.10 – a decline of more than 87%. The rebound in corporate profits over the ensuing decade of the 1920s saw the S&P’s per-share earnings rise to $22.91 by the end of 1929 – an increase of 558% over the decade.

Odd (eerie?) but true fun fact: Modern S&P earnings declined from a peak of $98.85 in 2006 to $17.32 in 2008 – a decline of 82% … and they have since rebounded by 553%. Things that make you go hmmmm?

Our (wrong) writer friend says the Shiller P/E back in the day “was very high because of very high stock prices, not very low average earnings.” Alas, the data scream, “Not True!”

Earnings rose in similar fashion in the decade before 1929, and in the decade before the modern peak. Here’s the relevant data, if you want to see it:

Both represent the same thing: The unleashing of pent-up consumer demand – only, in the modern era, that demand has been fueled not by true economic growth but by the assumption of debt. (But that’s a different story for another day.)

As for the era that inflated the 2000 tech-bubble … the data once again undermine the writer’s assertions. He claims “the strong economy more than made up for [the recession of the early 90s] in terms of company earnings it produced.”

Turns out, not so much, really.

Here’s the comparison:

S&P earnings bottomed at $28.34 per share in 1991, and peaked at $70.33 in 2000 – an average gain of 11% per year. S&P earnings bottomed at $17.32 per share in 2008, and in 2016 hit $95.84 – an average gain of 24% a year.

Clearly, the run up to the peak in 2000 was based not on superior earnings growth, but on the mindless euphoria tied to the idea that consumers would want to buy their dog food online because buying it at the supermarket was, obviously, much too inconvenient (gratuitous dig at Pets.com).

Simply put, the Shiller P/E today is no different than the Shiller P/E during previous peaks in 1929 and 2000: It rose off of cyclical lows to a level that ultimately led to the market’s comeuppance. It did so either because of euphoria tied to earnings growth after a massive collapse (1929, today) or because of euphoria tied to a secular change in the economy (2000). But in each instance, the peak valuation was (is) a warning sign of exuberance in the market. It was (is) a sign that investors were (and are) overpaying for stocks.

And the argument that low interest rates justify today’s egregious stock prices is a red herring.

If interest rates are heading up, as so much of Wall Street seems to believe, then that bodes poorly for stocks at some point and undermines our writer friend’s conclusion that as earnings continue to rise, they will push down the Shiller P/E.

This is in opposition to the historical truths.

If interest rates are rising – which squeezes the consumer – then corporate earnings are not likely to head up. Actually, they’ll grow much slower, assuming they grow at all, and more likely will stagnate or shrink. (And if we get into a Trumpian trade war, watch out).

Indeed, throughout U.S. economic history, periods of rising interest rates have coincided with periods of shrinking stock-market valuations. So low interest rates leading to higher stock valuations would be a solid argument if interest rates were heading down. But to argue low interest rates are a rationale for higher stock prices is kind of loony when rates are likely heading up (assuming the Fed isn’t lying).

Consider this chart I built based on Fed Funds data and S&P valuation data going back to 1980 … the green bars are periods when the Fed was cutting interest rates. The red bars are periods when the Fed was raising interest rates. Notice the trend? Rates go down, S&P valuations rise. Rates go up, S&P valuations go down.

I don’t care what level interest rates are at on a nominal basis. There are several periods of time in which some pundit could have used the same analysis that “interest rates are unusually low” to justify higher stock valuations. And you know what? It didn’t matter. The same trend played out.

So while low interest rates can certainly mean higher stock prices within reason, arguing that low rates deserve insane P/E ratios is historically myopic – just as it’s historically myopic to say the Shiller P/E today is warped by what happened in 2007. Historically simply begs to differ.

The truth is that stocks today are about as expensive as they’ve ever been in history.

And this will not end well.

It never has … and there’s no reason history should suddenly change now.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.