Stock market valuation remains stretched on long-term basis

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Although grossly oversold as far as short-term technical indicators are concerned, the S&P 500 Index remains expensively valued on a long-term cyclically adjusted PE (CAPE) basis, according to Robert Shiller‘s methodology. Shiller is economics professor at Yale and author of, among others, Animal Spirits, Subprime Solution and Irrational Exuberance.

In order not to work with notoriously unreliable forward-looking earnings estimates, I have always preferred using Shiller’s CAPE methodology, or normalised earnings, as they average ten years of earnings. This measure provides a good picture of the market’s value regardless of where we are in the business cycle. I have therefore been updating a CAPE chart for a number of years. On this basis, the multiple has declined to 21.9 since the July high of 25.9 (the May 2008 peak was 24.8), representing an overvaluation of 29.6% when compared to a long-term average of 16.9.

Although I am unsure whether the fat lady has made her appearance to signal the end of the cyclical bull market, the steepness of the recent equity declines could result in stock markets consolidating/edging up in order to work off a short-term oversold. On the fundamental front, a steep yield curve still provides a tailwind, but given the stretched valuations earnings growth becomes the key determinant for generating further gains. We’ll be watching this space very closely.

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1 comment to Stock market valuation remains stretched on long-term basis

  • Chris

    This chart is all well and good but it does not take inflation rates into account. For example, a pe of 10 would be expected when inflation is running at 10 to 15 % or more as it was in the 70/80’s.

    I thought the latest accepted methodology was to look at the yield over and above treasuries.

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