Should You Use 10-Year Average Earnings?

When people evaluate the stock market, they usually focus on whether the market is cheap or rich, and that usually focuses on earnings. But which earnings should you use? Conventional analysts tend to use projections for earnings over the next year. But some other analysts believe that’s a bad move. Forecasts of the next year’s earnings aren’t real, and they often aren’t produced. Using earnings forecasts is especially dicey at turning points, because analysts who forecast earnings tend to miss them.

The alternative is to use 10-year normalized or averaged earnings, sometimes known as the Shiller P-E ratio or CAPE. By this measure, stock indexes are highly valued at the moment, though conventional analysts say stocks are either normally valued or cheap. John Hussman of the Hussman funds calculates the P-E ratio using 10 years of earnings, and he says stocks are highly valued.

Some argue that this isn’t a good time to use the 10-year earnings method, because of distortions in the recent economic environment. The New York Times has a good piece giving both sides of this argument. It’s basically a debate between Jeremy Siegel on one hand and Rob Arnott and Robert Shiller on the other hand. If you consider stocks as an investment, this is an issue you need to have a position on. I favor using the 10-year P-E ratio, but you might have other ideas.

“I’m grateful that there are people who believe that, who can be on the other side of my trades,” Mr. Arnott says.

He points out that the past decade has also been witness to much monetary easing by the Federal Reserve, artificially bolstering corporate profits. Moreover, he says, “corporate earnings are the largest share of gross domestic product since 1929, while wages are the smallest share of G.D.P. since 1937.” Those trends are unlikely to continue forever, he says, adding that profit margins will eventually come down as the economy improves and companies start hiring more aggressively.