There is a lot of talk lately about whether or not the stock market is overvalued, undervalued or fairly valued. There are many different methods for determining whether a stock (or the whole market) is fairly priced based on some fundamental characteristic. Today we will discuss the usefulness of valuation methodologies.

Price To “Something” Ratios

The most common way to decide if a stock or index is fairly valued is to compare its price to some financial characteristic. The most common one is to compare its price to its 12 month trailing earnings. For example if a stock costs $10 per share and over the past 12 months it had earnings of $1 you would say it has a price to earnings (or PE) multiple of 10 ($10/$1).

Some people prefer to use other metrics to compare to the price besides just earnings. Some examples are price to book value, price to sales, price to EBITDA and many others. Others prefer to use future forecasted earnings estimates and compare it to the current stock price.

If we use the basic PE ratio using the usual 12 month trailing earnings we can compare that to the current price of the market to see how it is currently valued. The last reported earnings for the S&P 500 (March 2014) was 101.69. The current price of the S&P 500 as of this writing is about 1,995. This gives us a PE ratio of about 19.6. This number, however, doesn’t mean much without comparing it to other points in history. Going back to the late 1800’s the mean PE ratio is about 15.5 and the median is about 14.5. What this means is that you are paying a little more for each dollar of earnings today than you normally did through history.

The Shiller PE

Robert Shiller looked at the normal way PE ratios were calculated and had a problem with it. He figured that during a normal business cycle earnings will fluctuate quite a bit. If you were to look at a PE ratio at the top of the business cycle when earnings are relatively high you would think the market was cheap (earnings high compared to price). If you looked at earnings at the bottom of the business cycle when earnings are low you would think the market was expensive (earnings low compared to price).

Shiller corrected for this by using the last 10 years of earnings, adjusting them into today’s dollars and taking the average. He thought this would give you a much better idea of where earnings are compared to the current price. 10 years is arbitrary but makes some intuitive sense because it should include at least one business cycle. The current Shiller PE on the S&P 500 is about 26. Again going back to the late 1800’s the mean is about 16.5 and the median is about 15.5. Using this method the market looks even more overvalued.

So What Does This Mean?

If we dig a little deeper into the Shiller PE we can see that we are at a valuation level only seen a couple of times in history. Below is a chart created by Cliff Asness which looks at every rolling decade since 1926 and sorts them based on their starting Shiller PE. He then breaks all the starting Shiller PE’s into 10 groups. He calculates each groups average, worst and best real returns along with the standard deviation of those returns.

valuation 1

Depending on what day you are looking at the market we are either in group 9 or 10. Both don’t paint a rosy picture. When Shiller PE’s have been this high the average real return over the next 10 years has been between 0.5%-0.9%. There is hope however as the best real returns in these groups were between 6.3%-8.3%.

There are academics who still argue about the validity of this chart. Some look at it and dismiss it as too small a sample and other statistical problems. Others argue that the basic frame work is correct, but our current situation (low interest rates/two recent large recessions) make todays number irrelevant.

Personally I think this is a valid framework to think about market valuations even in today’s market. The statistical problems are more convincing, but even the biggest critics say the results cannot be ignored, but more data is needed to make it concrete.

So What Do We Do?

First let’s start with what NOT to do. Even if we assume the data can tell us something and we know that we are at a historically high valuation levels, it gives us no advantage in making a tactical decision on whether to sell stocks. Even looking at the last group above there is a very wide range between the best and worst returns. Just because markets may be overvalued today doesn’t mean we cannot have high returns. It just means that the odds are against us. We may very well have a great stretch of earnings in the coming years that make the current price look correct. Market valuations just don’t tell you much about short term market moves. One research paper shows that the Shiller PE’s greatest prediction power is looking at the next 18 years. For very short and very long time periods, Shiller PE did not do a very good job predicting the future.

What we can do is take this data point to mean that there is an elevated chance of market headwinds over the next 10-20 years. For those about to enter retirement, research shows that the most damaging time for poor market returns is in the first half of retirement.

The most obvious first step is to use a lower than the historically average rate of return for the stock market when forecasting your portfolio going forward. In financial plans this will result in either spending less or saving more. There is also new research showing that instead of continuing to become more conservative in retirement, it can make sense to be the most conservative early in retirement then increase portfolio risk as you progress through retirement. The idea is to reduce what is known as sequence of returns risk.

Assuming stock market headwinds also impacts other areas of your finances. Delaying your Social Security looks even better now since keeping money invested and taking Social Security earlier may not pay off as well. It can also influence a decision to buy an annuity or whether or not to take a lump sum pension.

The bottom line is that using any kind of market valuation tells you absolutely nothing about what the market will do next week or even next year. There seems to be, however, some predicting power over an intermediate time horizon. If you plan on spending down your investments soon it may be wise to adjust your outlook for stock returns (and bond returns, but that’s another post).