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Are We Entering Dangerous Territory?

|Includes: iShares Russell 2000 ETF (IWM), QQQ, SPY

I've written several articles over the past few years where I argued the market was not extremely overvalued when many used the historical average Shiller PE to highlight the market as being, well, extremely overvalued. The problem with using the historical average, as I see it, is including data from say the early 1900's to forecast the valuation of today's market is plain wrong; two different worlds. I'll discuss the methodology to give a basic understanding on how a conclusion (market valuation) is arrived at.

This method measures market risk over a set time based on Shiller. The Shiller PE (known for Yale University economist and professor Robert Shiller) is the current price of the S&P 500 divided by the past decade's average inflation adjusted earnings of the index.

The valuation data is derived from a rolling time frame to the present or the year under examination. Five median values are calculated for each period at the specified intervals. The interval that best fits the historical record is eight years. We'll look at a few examples to get a feel for how it works, specifically 1929, 2000 and 2007 followed by a current analysis.

The following color code definitions are:

  • Green - Market cheap to reasonably priced. Good time to find bargains

  • Yellow - Caution, more of a hold pattern. Bargains not as abundant

  • Red - Expensive. The period before a correction.

1929:

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