More Criticism About the Shiller P-E Ratio

About the only stock valuation measure that now indicates stocks are well above historic average values is the Shiller Price-Earnings ratio, known formally as the CAPE for Cyclically-Adjusted P-E ratio. It takes a 10-year inflation-adjusted average earnings to compute the P-E ratio instead of the last 12-months’ earnings or projected 12-months’ earnings. I’ve linked to some criticisms of the CAPE recently.

Here’s another discussion, this from the team at MainStay Marketfield. It is perhaps the most thoughtful and convincing criticism of CAPE that I’ve come across. Their basic point is that valuation measures are good tools for deciding when to buy an asset but not for deciding when to sell. When assets are highly valued by any measure it simply means that if there is an exogenous shock to the asset or a company, the value will revert to the long-term average or something less. But that doesn’t tell you when the shock might occur or what it will be. That is what money managers and financial advisors are for.

The only general lesson learned by studying historical market outcomes is the invariability of human nature and the limitless forms of folly that

can overtake entire societies.

In the case of current equity market valuations, there is no denying that the unusually depressed valuations that persisted in

the wake of 2008are largely a thing of the past. Stock prices have passed from the abnormally inexpensive phase to more normal levels. This is a process characteristic of all bull markets. It can be said that the easy money has been made, that we are passing from a phase of alpha

to beta in the asset allocation process. Understanding that one needed a greater than normal exposure to U.S. equities over the past five years was

the primary source of alpha (more return with less risk) for anyone with the responsibility for making broad allocation decisions. Now things

become less simple.

The next phase of advance in equity prices will be driven by the monetary inflation that has already created great valuation excesses in a

host of other asset classes. Its effect across various business sectors will be very uneven, with some benefitting unduly and others struggling to

maintain margins in face of accelerating cost pressures. In technical terms, the breadth of the advance should begin to gradually narrow.