Image credit: The New York Stock Exchange closes the door on its members, Sept. 20, 1873, Library of Congress
By Jason Zweig | 3:39 pm ET Jan. 15, 2016
Stocks have fallen far and fast, but not nearly enough to make them a bargain.
After all the carnage so far in January, including today’s big drop, the U.S. stock market has gone from very overpriced to overpriced. That, at least, is the signal being sent out by one measure of value, compiled by Yale University economist Robert Shiller.
As of Dec. 31, that measure stood at 26.1. At midday today, the measure had dropped to 23.6 — a decline of more than 9% over just 10 trading days.
But the long-term average is about 16.6. To get back to that level, the S&P 500 would have to fall to about 1310. That would mean a roughly 30% drop from today.
To derive the measure, called the “cyclically adjusted price/earnings” ratio, or CAPE, Prof. Shiller takes the current market price of the S&P 500-stock index, divides by the total earnings of the companies in the index averaged over the past 10 years, adjusting all the numbers to account for inflation. His measurement period goes all the way back to the year 1871.
So are stocks bound to go down by one-third — or even more?
Probably not. Even a historical average of 10 years’ worth of data can be hard to interpret. In March 2009, the CAPE fell to 13.3 times earnings — not much below the average ratio of 16.3 from 1871 through 2009. Many people, expecting the measure to bottom in single digits, as it did in 1982, 1974 and 1932, sat on their hands. But in 2009, CAPE still included the peak valuations of 1999 in its 10-year history — preventing it from seeming as obviously cheap, in foresight, as it now appears in hindsight.
And a study by financial researchers Elroy Dimson, Paul Marsh and Mike Staunton of London Business School has shown that long-term valuations predict future returns most accurately from either extremely low or extremely high levels.
An astronomical CAPE does tend to foretell low future returns; after CAPE peaked at 44.2 at yearend 1999, stocks lost an average of more than 3% annually in the next decade, counting inflation.
Less-elevated levels of CAPE, however, sometimes predict merely middling returns. If you had bought stocks in August 2002, when they stood at 23.6, approximately where they are now, you would have earned an average of about 6.5% annually over the next 10 years. That was roughly 4% after inflation — hardly a disaster, considering it includes the full swath of the 2008-2009 financial crisis.
So stocks definitely remain overpriced by historical standards.
They’ve gotten a bit less expensive in a big hurry, and they’re on the verge of reaching the levels from which they often offer decent future returns. But don’t let anybody fool you into thinking there’s some sure-fire way to get a singing telegram telling you when stocks are finally cheap enough to buy with both hands. Markets often bottom in ambiguity.
Source: WSJ.com, MoneyBeat blog