Are U.S. stock valuations too high, and what do we think about the Shiller P/E?Contributor Dr. David Kelly
Overall, we believe that U.S. stock valuations are close to fair value in absolute terms and cheap relative to bonds and cash. With regard to the Shiller P/E ratio, while we believe it can serve as a broad check on valuations, it has some theoretical drawbacks that prevent it from being our preferred measure of valuation.
As we show on page 5 of the Guide to the Markets, as of the end of March 2016, the forward P/E ratio on the S&P 500 was 16.6 times compared to a 25-year average of 15.8 times. Most other measures of valuation, including the dividend yield, the price-to-book ratio and the price-to-cash flow ratio, suggest the market is a little cheaper than over the past 25 years. However, the earnings yield on stocks (the inverse of the P/E ratio) remains well above the yield on Baa corporate bonds, implying that stocks are significantly cheaper relative to bonds than has typically been the case over the past 25 years. It can also be shown that the earnings yield on stocks is high relative to both inflation and short-term interest rates.
The Shiller P/E ratio, otherwise known as the cyclically adjusted P/E ratio, is calculated by dividing the S&P price index by the inflation-adjusted average of earnings for the prior 10 years. Professor Shiller, to his credit, publishes and updates the data, which go back to 1881. Since that time, the Shiller P/E has averaged 16.7 times, which has caused some concern among for investors who note that the current value is 25.6 times.
However, it should be noted first that P/E ratios over the past 25 years have been much higher than the average since 1881, with the Shiller P/E itself averaging 25.7 times, essentially the same as its current levels. There may be very valid reasons for higher P/E ratios in recent decades, including the ability of investors to reduce stock market risk through diversification and a gradual increase in the stability of the economy and earnings. Second, it should be recognized that the Shiller P/E is based on “as reported” earnings, which is quite a conservative accounting measure of earnings and which has become more conservative over time. Finally, it should be recognized that a generally lower inflation environment should justify a somewhat lower earnings yield on stocks just as it justifies lower yields on other assets. This reality is not reflected in P/E ratios in general including the Shiller P/E.
In summary, we believe that the U.S. stock market is at average valuations in absolute terms and is cheap when considered relative to inflation or the yields and bonds and cash. The Shiller P/E ratio, while useful as another measure of valuation, doesn’t incline us to change that view.
U.S. equity valuations look average in absolute terms and cheap relative to bonds and cash, suggesting that an overweight to U.S. equities is still justified in the context of an appropriately balanced portfolio.
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