Market Valuation

P/E10 Ratio

On August 6, 2010, the P/E10 ratio was 20.60 and the S&P 500 Index 1121.64. The historic average P/E10 ratio is 16.3 and the historic real market return (inflation corrected) is 6.5% compounded annually. P/E10 ratio of 20.60 is 26.38% above the average and in the High Value P/E10 ratio range of 20 to 25. Given a P/E10 ratio of 20.60, the probability is that an investment in the market made today and held ten years will have a real return of 2.80% compounded annually. However, the real 10-year return could be anywhere within the range of -5.0% to 15% compounded annually (see P/E10 ratio probability of real return chart below).

Benjamin Graham and David Dodd, in their famous 1934 textbook “Security Analysis,” said that for the purpose of examining valuation ratios, one should use an average of earnings of “not less than five years and preferably seven or ten years” (p.452). The statement recognizes the fact that short-run valuation ratios do not present a clear picture of value. R.J. Shiller acknowledges that he took their advice to create the P/E10 ratio.

P/E 10 ratio (“CAPE”) or Cyclically Adjusted Price Earnings Ratio is an average of real (inflation-corrected) earnings over the past ten years and that number is divided into the real (inflation-corrected) S&P 500 Index (“S&P 500”) to calculate the P/E10 ratio. The P/E10 ratio responds to long-run variations in the level of stock prices. The record high for the P/E10 ratio of 44.9 at the start of 2000 dwarfed the previous 1929 record of 28.0 and forecasted poor long-run equity returns for the 2000s. If one compares real current earnings to the P/E10 ratio earnings it is clear that the record high P/E10 ratio of 44.9 was caused by price growth and not earnings growth. For the period 1871 to February 2010 the average P/E10 ratio is 16.3.

CAPE_August_2010

Courtesy of R. J. Shiller

Index_August_2010

Courtesy of R. J. Shiller

The P/E10 ratio, invented by Robert J. Shiller, Arthur M. Okum Professor of Economics, Yale University, is widely used by top money managers to determine market valuation. In 2001, R.J. Shiller published the paper “Valuation Ratios and the Long-Run Stock Market Outlook,” which was based on his testimony before the Board of Governors of the Federal Reserve System in 1996 and 1998. The testimony was that stock market returns are hard to forecast in the short-run, but the simple theory of mean reversion is basically right and it predicted poor long-run stock market returns. The paper proves the mean reversion thesis and the value of the P/E10 ratio to determine market valuation and predict long-term real stock market returns. The P/E10 ratio is a good predictor of long-term stock market returns, but history indicates it can stay in overvalued or undervalued ranges for long periods of time.