Research Articles

The Shiller PE Continues to Mislead Investors, The S&P 500 Is Fairly Valued in Early 2013

Chuck Carnevale - Tuesday, January 15, 2013

Allow me to start this article by emphatically stating that I have a real problem with forecasting stock markets in the general sense.  Instead, I prefer to forecast the intrinsic values of individual businesses based on their earnings justified fundamental values.  I hold this position because I believe that it is not only possible, but also quite practical to analyze a specific business and then make an intelligent forecast (not a guess) but a rational estimation, based on the assimilation of fundamental facts, as to its past, present and future intrinsic value.  Importantly, I’m not suggesting this can be done with absolute perfect precision down to the precise penny, rather I am suggesting it can be done within a reasonable range of rational probabilities.

In contrast, trying to estimate the collective results of a large group of companies such as the S&P 500 (SPY) is a very daunting task.  There are just too many variables and too many data points to contemplate from which to make a rational and/or reasonably accurate forecast. On the other hand, the evidence I’ve reviewed suggests that the earnings and price correlation and relationship is just as valid on an index, as it is on an individual stock.  In other words, earnings will be the primary driver of stock price for both a specific company and an index.

With the above said, I have been periodically posting articles relating to the valuation of the S&P 500 based on the earnings and price correlated fundamentals analyzer software tool F.A.S.T. Graphs.    My rationale for engaging in an activity that I generally eschew is born of my desire to help people to being better informed investors.   To my way of thinking, this means injecting more fact-based information into our analysis and less opinion. Facts provide information that can be quantified and evaluated.  Opinions, on the other hand, are often emotionally-charged which can lead to irrational responses and behaviors. Therefore, I feel that the emotional response does not belong in something as important as making prudent investing decisions. Reason should dictate behavior rather than emotions such as fear or greed.

Allow me to try to clarify this a little more by presenting the current earnings and price correlated F.A.S.T. Graphs™ on the S&P 500 since calendar year 1993. The orange line on the graph plots earnings-per-share at the historical normal PE ratio of 15. The reader should note that the blue line on the graph represents a historically normal PE ratio of 19 over this time period.  This simply indicates that for much of this time frame, that the S&P 500’s stock price was in overvalued territory.  Importantly, notice how the stock price tracked the orange earnings justified valuation line, and that whenever it deviated away from the line it inevitably moves back towards alignment. Today, with a blended PE ratio of 14.8 the S&P 500 is reasonably valued. (Note: that because of the long duration of this graph, that only every other year is typed in, although data for all years is plotted).

At this point, it’s important to state that historical F.A.S.T. Graphs™ valuation measurements are based on actual S&P 500 operating earnings as reported, and estimated earnings (numbers marked with E for estimate) come directly from the Standard & Poor’s website. This is in contrast to the very popular statistical S&P 500 valuations based on the Shiller PE ratio calculation known as CAPE which utilizes earnings calculated as a 10-year average.  If you carefully study the earnings and price correlating graph above, it is obvious that earnings for the S&P 500 (the orange line) have mostly advanced with the exception of the two recessions of 2001 and 2008. 

This is important, because mathematically speaking the 10-year average of an advancing number will most often calculate earnings to be lower than they actually are. Of course, the exception would be when you’re calculating a 10-year average during a recessionary period when earnings have fallen. The point is that the only way that the Prof. Shiller statistical calculation can be correct is if future earnings fall. Again, an average of 10 years worth of increasing numbers will, mathematically speaking, always be lower than the current number. However, the problem is that as the graphic clearly indicates, earnings of the S&P 500 increase much more often than they fall.  This clearly, at least, has been true for the last couple of decades.

This creates a problem for investors that I find appalling. For the great majority of the time, the Shiller calculated PE ratio will generally indicate that the market is overvalued.  Consequently, investors who buy into this thesis will generally tend to avoid investing in stocks.  Yet, if they were to calculate valuation based on actual numbers, they would more often than not find that stocks are fairly priced to even cheap, instead of overvalued. Therefore, they are often avoiding stocks at precisely times when the risk of investing in them is lowest, and simultaneously, when the rewards for owning them are highest.

To further illustrate my point, here is an article published on 10/12/2011 where real earnings data indicated that the S&P 500 was cheap with a PE ratio of 12.6 based on the then estimated earnings for the S&P 500 for 2011 of $97.98.  Actual 2011 earnings came in slightly lower at $96.44 (1.6% lower than originally estimated), but still represented a 15% advance over 2010. Consequently, the S&P 500 was still trading at a PE ratio below 13, and less than its historical normal PE of 15.  Unfortunately, the Shiller PE for the S&P 500 was at 20.15.  Since anything over 16 is considered expensive, CAPE was declaring that the S&P 500 was overvalued, not undervalued.

The following earnings and price correlated graph shows the S&P 500 at a price of 1194.89 on October 10, 2011.  As of this writing, the S&P 500 is priced at 1472.05 or approximately 23% higher than it was in October of 2011. Therefore, investors believing in the Shiller statistical PE missed out on a great buying opportunity.  

 

In the spirit of accountability, the following are links to several other similar articles to this one, utilizing the actual PE of the S&P 500 based on real earnings and the near estimate of future earnings.  For perspective, I’ve reported the date the article was published and the respective Shiller PE ratio on that date. Once again remember that according to Prof. Shiller, his statistically calculated PE ratio has to be approximately 16 or lower for fair value to exist. All of the following examples show that the Prof. Shiller CAPE (Cyclically Adjusted PE) would have caused investors to avoid investing in equities when the opportunities in doing so were high, and the risks based on valuation low.

When this article was written on January 6, 2010, the Shiller S&P 500 PE was 20.52 indicating overvaluation.  The F.A.S.T. Graphs calculated PE on actual earnings of 19.1 agreed.

However, by February 21, 2010 when I published this next article the Shiller S&P 500 PE was 19.91 still indicating overvaluation.  However, it is interesting to note that earnings forecasts for both 2008 and 2009 ended up being lower than the actual results.

Then on November 2, 2010, I published an update suggesting that the S&P 500 should reach 1254 by year-end based on estimated earnings, the Shiller S&P 500 PE was 21.69 continuing to say that the market was overvalued.

When I published the next article on December 23, 2010 the Shiller S&P 500 PE of 22.39 was still indicating overvaluation. But as actual earnings were higher, the S&P 500 target of 1254 was reached.

By January 9, 2011, I published this article when the Shiller S&P 500 PE 22.97 continued to suggest overvaluation even though the Index continued to make above-average returns for those investors with the foresight to focus on actual earnings rather than a statistical representation.

When I published an article on April 7, 2011  the Shiller S&P 500 PE of 23.05 continued to relentlessly suggest overvaluation.  Nevertheless, the market has advanced approximately another 10%, from 1333 to 1472, since that time. Yet all of the gains were achieved during times when the Shiller PE was suggesting that stocks were overvalued.

Since the beginning of 2010 when the first article I cited above on the valuation of the S&P 500 was published, the S&P 500 has produced a compounded annualized rate of return of 11.6% (including dividends), while all the while, the Shiller PE was screaming overvaluation. In contrast, the valuation based on the actual earnings of the S&P 500 suggested reasonable valuation.  The following performance results since December 31, 2009 illustrate what investors, afraid of owning common stocks, missed out on. 

This is why I prefer decisions based on facts over decisions based on artificial constructs and mere statistical representations such as CAPE.  Perhaps if you keep yelling that the sky is falling long enough, it may one day occur.  However, where I sit, it appears that that may be a long way off. Therefore, I much prefer serious analysis based on the facts that I do some hypothetical estimation based on what can be very misleading statistics.

A Fair and Balanced View

However, and in order to be fair and balanced with this article, the following F.A.S.T. Graphs looks at the S&P 500 since January 1, 2009 when the Shiller PE ratio was at 15.17 indicating undervaluation.  From this picture, it is clear that both real operating earnings and the CAPE (Shiller’s Cyclically Adjusted PE) both indicated fair value.  However, it’s important to recognize that this was a time when the S&P 500’s earnings had actually fallen from $87.72 in calendar year 2006 to $49.51 by 2008.  In other words, the Shiller CAPE was accurate because it was measured at a time when S&P 500 earnings had fallen for two consecutive years in a row, and just prior to strong S&P 500 accelerating earnings growth coming off of the low base.

Consequently, the S&P 500 performance when the Shiller PE ratio was at 15.17, indicating a solid buy, was exceptional.  However, it was also during a time when the S&P 500 was moderately overvalued based on actual earnings, and just prior to the strong earnings advance previously mentioned and illustrated.

A Few Words About Specifics Versus Generalities

As I indicated in my opening remarks, I prefer analyzing individual companies over attempting to forecast the earnings of a broad market like the S&P 500. One of my primary reasons for believing this is that my research has suggested that in every market, whether bull or bear, there can always be found overpriced, underpriced or fairly priced individual selections among the group. Therefore, I believe in making specific decisions rather than general ones.

Since a picture is worth 1000 words, I am going to present earnings and price correlated graphs on the following three well-known S&P 500 stocks to illustrate my point.  I will let the graphs speak for themselves and offer only this brief explanation.  When the price is above the orange earnings justified valuation line, the stock is overvalued, when below the line, undervalued, and when on the line (or very close to it), fairly valued. Therefore, I offer Home Depot (HD) as an overvalued S&P 500 company, Johnson & Johnson (JNJ) as a fairly valued example, and finally Aflac (AFL) as an undervalued company.

Summary

With a blended PE ratio of 15, I believe the S&P 500 is fairly valued based on real current and near forecast earnings.  My optimism rests on the idea that the world economy is improving coming out of the great recession, and that we will soon see significant productivity enhancements as the deployment phase of the information revolution comes into high gear.  Moreover, I believe that high-profile blue-chip publicly-traded US companies are well-positioned for profitable long-term growth. The great recession of 2008 forced many of them to take long hard looks at their balance sheets and P&L’s. As a result, I believe corporate America is leaner and meaner, so to speak, than they have been in a long time. Consequently, productivity enhancements should feed their bottom lines.

In their October 5, 2012 edition, Trends Magazine published an article titled “The Truth About Stocks.” A few select excerpts from the article both summarize and highlight my optimistic views:

On the Market’s Long-term Record

“Since 1912, the inflation-adjusted total return for investments in common stocks has averaged 6.6 percent per year, compounded. That’s 100 years of solid performance despite numerous surges and crashes.

Any way you slice it, it’s an impressive record.

But, after more than 12 years of minimal price appreciation and weak dividend performance, many investors find themselves asking the question, “Will we ever see 6.6 percent average annual returns again?”

On Future Earnings Growth

“As soon as 2014, we’ll begin to see rapid economic growth return; the exact timing will depend on policy factors that are hard to predict. Houses will begin to move, demand for autos will grow, and sales will pick up in retail stores. As a result, corporate profits will grow at a renewed pace, which will drive up stock prices. As long as long-term interest rates move up, improved investor confidence will eliminate much of the pervasive “worry deficit” that’s held down “relative P/E ratios” for a decade. Another factor contributing to equity returns will be demographics: Domestically, solid birth rates plus immigration will create demand for more goods and services. Although it’s true that Europe and Japan will remain stagnant due in large measure to aging and declining populations, this will be more than offset by The $30 Trillion-a-Year Opportunity of 2025 discussed later in this issue.”

On the Sources of Growth

“Second, in the coming decade, total returns on stocks should actually exceed historic norms, as the Deployment phase of the global Information Revolution takes off.

This phase will drive the biggest boom in world history, providing the “productivity miracle” Bill Gross could evidently not imagine happening. This boom will materialize for a number of reasons. Here are a few:

This is the first time that over 5 billion people living in the developed world will take part in this type of revolution; previous revolutions have been limited to the developed world.

New technologies will make low-cost energy available in enormous quantities.

The combination of infotech, biotech and nanotech will dramatically increase the amount of GDP that can be produced per unit of matter and energy, eliminating much of the traditional drag created by resource shortages.

Increasingly, the most valuable resource will become information, which can be made available to almost anyone, anywhere, at any time for free once it is created. “

The bottom line to my thesis is that I expect future earnings of the S&P 500 to be higher than they are today, not lower, as the Shiller PE would want you to believe. On an absolute basis, in other words, on actual current earnings, I believe the S&P 500 is fairly priced.  In my experience, when the markets in general are fairly priced, it is easier to find fairly priced individual selections than it would be if the market were truly overvalued. Furthermore, like all markets there are overpriced stocks in the general market, I shared an example with Home Depot above. Nevertheless, there is plenty of value to be found for the discerning investor willing to dig deep enough.

Conclusions

I believe there is no substitute for making intelligent decisions based on factual information.  Having an intelligent framework with which to make investing decisions can eliminate mistakes that are too often made when emotion is overtaking reason. Within this process, I believe it’s important to recognize that over the vast majority of the time, positives outweigh negative.  Therefore, it’s important to realize that negative economic cycles such as recessions only come rarely, and usually end rather quickly.  So, I suggest that instead of being traumatized and frightened away, it’s worth considering that the best times to be looking at equities is when times are tough.  Because, it is during these times when great businesses go on sale.

Disclosure:  Long HD, JNJ and AFL.

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

Comments
Post has no comments.
Post a Comment




Captcha Image

{tag_blogid}
Trackback Link
http://www.fastgraphs.com/BlogRetrieve.aspx?BlogID=419&PostID=803097&A=Trackback
Trackbacks
Post has no trackbacks.

Dividend Champions*

Live F.A.S.T. Graphs can be activated by clicking on one of the links below, which includes most Premium graphing options:
=> Get LIVE FAST Graphs (MSFT)
- - - - - expires: 02/13/2013  - - - - -
=>Get LIVE FAST Graphs (AAPL)
- - - - - expires: 11/29/2012  - - - - -

Testimonials

“I appreciate your work, Chuck. As a subscriber to FAST Graphs™, I use the tool to decide on whether to purchase additional shares of what I currently hold or to add a new holding. Your articles help me make full use of the tool and give other readers valuable information, if they take the time to learn. One of the biggest enhancements that I use is the FFO data added for MLPs and REITs.”


“When FAST Graphs™ were unavailable because of Hurricane Sandy, I realized how much I need them in order to make investment decisions.

(Wish I could be) Long FAST Graphs!!!”


“One more vote for the value of FAST Graphs™; just started a subscription to Chuck's great service (premium), and am having a ball analyzing so many stocks quickly.”


“I feel very ill-equipped to make investment decisions without Fast Graphs. :-)”


“Yesterday, I signed up for your F.A.S.T. Graphs™. It's a really amazing, valuable tool for checking over/undervaluation of stocks. Wish I had it years and years ago!!”


“Love the F.A.S.T. Graphs™: One glance and you know a whole lot.”


“About Chuck's F.A.S.T. Graphs™: They are invaluable to me in making decisions about the stocks I own (in addition to what you are saying about doing other research) and the ones I hope to own in the future.”


"Chuck -- Your proprietary F.A.S.T. Graphs™ are a VERY impressive tool!"


“If there were an Investor Hall of Fame for people who have helped others with their investing, and sharing valuable information, you and your F.A.S.T. Graphs™ would get one of my selections.”


“I love Chuck's F.A.S.T. Graphs™! Well worth the price of admission for what he gives you.”


"Chuck - Thank you for your well thought out articles. I tend to be a visual type of person so I really appreciate the F.A.S.T. Graphs™ approach."


"Great article, as always! I always look forward to your articles, and am especially eagerly awaiting your next in this series. I find the F.A.S.T. Graphs™ extremely helpful."


“Your F.A.S.T. Graphs™ put all of this in a single artful picture and the accompanying spreadsheets hammer home the point.”


“I use the F.A.S.T. Graphs™ method to evaluate all of my ideas. I recommend it for individual investors, since it helps them focus on data and get past the many emotional arguments.”


“I recently subscribed to the F.A.S.T. Graphs™, and these articles are helping me learn how to better use them. They really do give you a good quick look at the valuations picture. A much needed tool!”


“I also always appreciate the clear-cut information provided through your F.A.S.T. Graphs™ and articles.”


“Thanks, Chuck, for your F.A.S.T. Graphs™. Each of these graphs is worth 1,000 words in describing a company's growth, consistency and valuation. Thanks for sharing your graphs.”


“Thanks, Chuck. Love the F.A.S.T. Graphs™! It makes investing so much more clear.”


“Chuck's F.A.S.T. Graphs™: They are invaluable to me in making decisions about the stocks I own (in addition to what you are saying about doing other research) and the ones I hope to own in the future.”


”I am amazed at the usefulness of your F.A.S.T. Graphs™ and I plan on using them for a long time to come.”


“Chuck's F.A.S.T. Graphs™ will give you a tool to find those well chosen stocks...”


“Thanks for the F.A.S.T. Graphs™, Chuck. They are the best tool I've used.”


Recent Posts


Tags

QCOM GPC ADM food service ESRX Valuation MCHP BKH CNSL macro JCI M MSFT CAPE SPY DHR WST MELI BOFI EMR GME WLP AMCX CLX,EMR TNGO COO ARRS LL JNJ ESI IR ITW, DD BNS. UTX TNC NKE LOW HD PKG CACI retirement ALB AFL ECHO DOV CAT VRTU HP OSIS ODFL HON REXX RRD TIF UN SYT long-term investing NSR C DR AVD CPN JPM MNTX MDT EAT HNZ CSCO COP EE NOC long ideas KMP TOT QCOR LQDT Market Outlook ADP RAI ORCL MMM IBN market currents TAC AA KO,CLX,CELG,JCP,GT,MSI,PEP,ED WFC BCR OUTR TEG: WEC: OKE SILVER CVS TIS MRK BOBE ACI COST ACM stock research tool FOSL BHP BCOR EMC NFLX PBI GEOS CBU NSRGY CHE SCL STE ED POWR SLW DMRC KFT WEC GD LH ACN diversified machinery FF LO PFG AXP CAH CLX MGRC POM Macro view LLL SHOO MGEE AMT DAN MTZ TWGP RKT BR T BWP AEP BMS PEP EV SWKS CLF BAX STMP PM DLR HII PCP MNST GILD UHS OGE MIDD NEE TGT TE JSFT ASNA RDS.A NSC IPAR AGLP stocks APEI Fundamentals D RIMM economy DORM SUBX WRLD CKSW MKC Utilities SYY IBM TRV MO DRC ACOM PSX NLY CAM FCFS SLGN DTV PEG MSA stock analysis BH CTRX RSG,RTN PPG SAM FDO FTI,HTZ RTN DOW HAS value investing KMB FRAN CACC TGH XOM XEL ZUMZ WIN investing for income,growth and income consumer JCOM DELL LMT BBY ENSG DGAS AOS INWK LTM ULTA GWW GPS GOLD SBUX XRX SEIC ORI MUR AAPL AZZ Dividend Ideas machinery DTE CASY CHD CLR COH SON CHS MHP AVP intrinsic value PG DFS ROST MATW GE TMP SHW DVA P BMRC THRM KO MCD WGL PRGO ONE CMI AET TXT dividends,earnings growth HRL VMI technology CPB Utilities Sector long-term growth V POR DIS WWW CSL TWX BRLI ATW 3NSRGY NVS GMCR ABC SYK PNRA due diligence LXU TSCO UNP EXLS CRI ED:SCG TU market BCE PFE ABT earnings ACE BEN JAZZ INT APD RCII FAST DNB AM ALTE dividends NC DRI BWLD KR INGR OHI earnings growth RMD ROSE CTCM PPL INTC SPLS HE FC investing for income BA CBI EMR, MMM AZO CL EK EPHC URI ANDE BLK VVC FUL FLO BBBY CB FTR IR, CTG GIS KMT AMGN HCI PDFS AMZN TEVA CELG GES JRN FBHS CSX KSS WFM K BAC LKQ Telecommunications DTEGY CERN PNM PCLN SCG HPQ IDA SNCR NOG plots earnings SNH BDX EXC BLL FAST Graphs SWK CTSH DE WMT FISV PNR CBRL GOOG AFSI BAP SJM VFC OKS UNH SIG OXY UL CTL WAG CVX RSG COL BRS investment stock research TEF HRS APH ITC UEPS VZ MNR ADT SXL DPS Stock Research Analysis EBAY MHS BEAV FRED LEN short ideas ITW SO POT MTW ETR OII BG GT DGX PRAA MCY JWN RRC PNW SU ARLP SFG

Archive

Testimonials

“I appreciate your work, Chuck. As a subscriber to FAST Graphs™, I use the tool to decide on whether to purchase additional shares of what I currently hold or to add a new holding. Your articles help me make full use of the tool and give other readers valuable information, if they take the time to learn. One of the biggest enhancements that I use is the FFO data added for MLPs and REITs.”


“When FAST Graphs™ were unavailable because of Hurricane Sandy, I realized how much I need them in order to make investment decisions.

(Wish I could be) Long FAST Graphs!!!”


“One more vote for the value of FAST Graphs™; just started a subscription to Chuck's great service (premium), and am having a ball analyzing so many stocks quickly.”


“I feel very ill-equipped to make investment decisions without Fast Graphs. :-)”


“Yesterday, I signed up for your F.A.S.T. Graphs™. It's a really amazing, valuable tool for checking over/undervaluation of stocks. Wish I had it years and years ago!!”


“Love the F.A.S.T. Graphs™: One glance and you know a whole lot.”


“About Chuck's F.A.S.T. Graphs™: They are invaluable to me in making decisions about the stocks I own (in addition to what you are saying about doing other research) and the ones I hope to own in the future.”


"Chuck -- Your proprietary F.A.S.T. Graphs™ are a VERY impressive tool!"


“If there were an Investor Hall of Fame for people who have helped others with their investing, and sharing valuable information, you and your F.A.S.T. Graphs™ would get one of my selections.”


“I love Chuck's F.A.S.T. Graphs™! Well worth the price of admission for what he gives you.”


"Chuck - Thank you for your well thought out articles. I tend to be a visual type of person so I really appreciate the F.A.S.T. Graphs™ approach."


"Great article, as always! I always look forward to your articles, and am especially eagerly awaiting your next in this series. I find the F.A.S.T. Graphs™ extremely helpful."


“Your F.A.S.T. Graphs™ put all of this in a single artful picture and the accompanying spreadsheets hammer home the point.”


“I use the F.A.S.T. Graphs™ method to evaluate all of my ideas. I recommend it for individual investors, since it helps them focus on data and get past the many emotional arguments.”


“I recently subscribed to the F.A.S.T. Graphs™, and these articles are helping me learn how to better use them. They really do give you a good quick look at the valuations picture. A much needed tool!”


“I also always appreciate the clear-cut information provided through your F.A.S.T. Graphs™ and articles.”


“Thanks, Chuck, for your F.A.S.T. Graphs™. Each of these graphs is worth 1,000 words in describing a company's growth, consistency and valuation. Thanks for sharing your graphs.”


“Thanks, Chuck. Love the F.A.S.T. Graphs™! It makes investing so much more clear.”


“Chuck's F.A.S.T. Graphs™: They are invaluable to me in making decisions about the stocks I own (in addition to what you are saying about doing other research) and the ones I hope to own in the future.”


”I am amazed at the usefulness of your F.A.S.T. Graphs™ and I plan on using them for a long time to come.”


“Chuck's F.A.S.T. Graphs™ will give you a tool to find those well chosen stocks...”


“Thanks for the F.A.S.T. Graphs™, Chuck. They are the best tool I've used.”