Chas Craig, BridgeTower Media Newswires
Today we revisit the Shiller Cyclically Adjusted P/E (CAPE) Ratio, which takes the price of a representative stock index and divides it by the inflation-adjusted earnings for the preceding 10 years with the aim of observing how normalized earning power over a business cycle (crudely defined as 10 years for simplicity) is being valued. While no metric can reliably predict short-term stock market returns, over long periods (i.e., 10 plus years), higher-than-average starting Shiller valuations have tended to be associated with lower-than-average subsequent returns, and vice versa.
A long-term graph of the CAPE Ratio for the S&P 500 is available at multpl.com/shiller-pe. Upon examining the graph, today’s valuation at 28.8x is still elevated compared to the full data series back to the late-1800s where the visual midpoint is roughly 20x. However, with recent price declines, today’s reading is down markedly from roughly 38x at the outset of 2022. With the benefit of hindsight, 38x was a historically worrisome level and is only dwarfed by the plus 40x readings around the turn of the century.
However, higher than historically normal CAPE levels can be justified presently by several factors such as:
• A recently lowered corporate tax rate (although subject to change along with the political winds) means that prospective earnings will be higher, all else equal.
• The U.S. economy is less cyclical than it once was, owing in part to more accommodative central bank policy on average (notwithstanding the current inflation fight) and an increasing amount of non-discretionary government expenditures as the population ages (e.g., Social Security).
• The U.S. stock market has a much larger weighting to higher multiple technology companies now than historically.
A bullet point that could have been included with the above three at the beginning of 2022, but no longer, is:
• Interest rates are much lower than historically normal, which makes all financial assets worth more intrinsically, all else equal.
The 10-year Treasury note now yields 4%, reasonably close to the late-1987 to present average of 4.5%, compared to 1.5% as of the start of the year.
When examining the long-term CAPE graph, one will note that for a little more than a century ending in 1987 the average Shiller P/E Ratio was about 15x. While a low of 5x was seen in the early 1920s and a high of 30x reached in the bubble that immediately preceded the Great Depression, the normal range was 10x to 20x. Since 1987 the low Shiller P/E reading has been roughly 15x, consistent with the average of the century which preceded it. This valuation level was reached in the aftermath of the 1987 “Black Monday” stock market crash and in the throes of the Financial Crisis. Of course, the high of nearly 45x was reached at the apex of the dot-com bubble near the turn of the century.
I invoke Black Monday because it is the birthday of the “Fed Put,” when then-Fed Chairman Alan Greenspan assured investors that the central bank was committed to stabilizing markets, implicitly providing a backstop for the stock market.
Bottom line, one could view a 30x CAPE (i.e., the approximate post-1987 midpoint) as a reasonable fair value estimate for the S&P 500. Viewed through this lens (Of course, there are many others worthy of consideration, not all of which point in the same direction.), the U.S. stock market has swiftly moved to a state of modest undervaluation in 2022.
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Chas Craig is president of Meliora Capital in Tulsa (www.melcapital.com).
