YOUR MONEY-Shiller's math says the market looks expensive
NEW YORK, Aug 22(Reuters) - Here is a worrisome thought for all the analytical investors out there: What if all this time, you have been looking at the wrong numbers?
Consider this: When you are mulling over whether to buy a stock, you are likely to look at the price-earnings ratio, a common metric for valuing companies. A low P/E suggests that a stock is relatively cheap; a high one suggests it is richly priced.
But maybe you should be crunching a different set of data.
Some market watchers prefer what is called the "Shiller P/E," named after Yale University economics professor Robert Shiller. Instead of comparing price and earnings data for the last 12 months, or forecasting it for the next 12, the Shiller P/E relies on the previous 10 years of inflation-adjusted data.
Investors who rely on the Shiller P/E point out the longer-term ratio evens out factors like economic booms and busts, and discounts overly bullish earnings predictions from company executives. It gives a more accurate understanding of a firm's true value, they say.
"From one year to the next, earnings can vary widely," says John Mauldin, chairman of Dallas-based research firm Mauldin Economics. "The reason you use the Shiller ratio is to smooth out those earnings gaps, and get better historical context."
So what is it telling us now? The Standard & Poor's 500's trailing P/E now stands at 16.87, above its long-term historic average of roughly 15.5, but not egregiously so.
The Shiller P/E for the S&P 500, on the other hand, is 23.2. That is 40.6 percent higher than its historic mean of 16.5, even after the recent selloff, and suggests limited upside for equities going forward.
"You can use the Shiller P/E to project future returns, and right now it suggests those returns are not going to be very robust," says Mauldin. "With these valuation levels, you are looking at something like 1-3 percent returns for equities over the next 10 years, which are quite low."
But even Shiller himself thinks that equities may continue to perform better than other investment choices: "Even if real returns for equities will only be something like 3 percent a year going forward, that still compares favorably to long-term bond yields," he said in an interview. Furthermore, bonds are projected to lose value if interest rates rise over the next few years.
"Of course stocks are riskier than bonds, but I am still inclined to think that equities should remain a substantial part of investors' portfolios."
The key, he says, is diversification - instead of just buying an index that looks pricey, choose a more narrow and reasonably priced basket of stocks.
For example, the Barclay's exchange traded note, the Shiller CAPE ETN, allots stronger weighting to sectors that are relatively undervalued according to the Shiller P/E.
You could also isolate individual stocks with reasonable Shiller P/Es, at research sites like GuruFocus.com. That does limit your universe of potential investments, since the calculation requires the company to have been around for at least 10 years.
Not everyone is sold on the Shiller P/E.
"It is one way of looking at earnings, but it is not the only one," says David Bianco, chief U.S. equity strategist for Deutsche Bank.
In fact, by Bianco's calculations the market is still in fair-value territory, since slightly elevated P/Es are commonplace in a low-interest-rate environment. As a result, he suggests that investors shouldn't be spooked by the Shiller number.
"You would have been scared off last year, and the year before that," says Bianco, pointing out that such investors would have missed out on a raging bull market. The Shiller P/E "has consistently signaled an overvalued market, and if you let it drive your decisions, you likely would have been out of stocks entirely."
Investors have seen rather remarkable gains with the S&P 500 up around 140 percent from its March 2009 lows. For those fretting about a lofty Shiller P/E, Mauldin suggests a prudent course of action: Keeping some powder dry, in cash.
"The worst thing investors can do is think that they have to put all their money to work, right away," he says. "No, you don't. If valuations like the Shiller P/E seem high, just wait, and they will come back."