Robert Shiller said last week that stocks are far more expensive than their current price-earnings ratios suggest. Shiller uses a cyclically adjusted price earnings ratio to determine whether the stock market is cheap or expensive. Theoretically, Shiller is right. Focusing on only one year’s earnings will mislead investors at the top or the bottom of business cycles. At the top of a business cycle, earnings are usually much higher than their normalized level. At the bottom of a business cycle, earnings are usually much lower than their normalized level. So Shiller suggested to smooth earnings by calculating average earnings over the previous 10 years. He calls this “cyclically adjusted price earnings ratio“.
The problem with Shiller’s approach is that there are no guarantees that average earnings will approximate “normalized” earnings. Annual earnings aren’t normally distributed. So using a sampling size of 10 may not always yield an average earning number close to the “actual” normalized earnings. If you have artificially high earnings during the previous 10 years, you will overestimate. If you have artificially low earnings during the previous 10 years, you will underestimate.
Shiller thinks stocks are currently 40% overvalued. He thinks the recent earnings increases are artificial and corporate profits will shrink by around 40% over the next few years. We don’t think so. Bloomberg doesn’t agree with Shiller either. Bloomberg published the following reasons why stocks are cheapest in 26 years:
1. Standard & Poor’s 500 Index companies will earn 18 percent more this year than in 2010, according to the average estimate of more than 9,000 analysts compiled by Bloomberg.
2. Losses since April have pushed the price of the S&P 500 to 14.5 times the past year’s earnings, compared with the average of 20.5 since June 1991, according to Bloomberg data.
3. The price of the S&P 500 is only 8.7 times cash flow, cheaper than in 81 percent of occasions since 1998.
4. The price of the S&P 500 is only 2.1 times book value, or assets minus liabilities, lower than it has traded 90 percent of the time since 1995.
5. S&P 500 earnings may rise to $99.61 a share in 2011 from $84.58 last year and $61.52 in 2009, according to data compiled by Bloomberg. Should stocks stay at current prices and the analyst prediction come true, the S&P 500 would trade at 12.8 times income on Dec. 31, the lowest level since 1985 except for the six months after Lehman Brothers Holdings Inc.’s bankruptcy in September 2008 and nine months in the late 1980s, according to Bloomberg data.