Unexpectedly Intriguing!
May 27, 2009

Papa Shango (aka Ironman at Political Calculations in more care-free days!)As an investor, should you panic that stocks have become overvalued, at least as measured by Robert Shiller's P/E10 ratio?

The P/E10 ratio is similar to the well-known Price-to-Earnings ratio (also known as "the P/E ratio"), but instead of simply using trailing year earnings per share in the denominator, Shiller has popularized Benjamin Graham and David Dodd's method of incorporating the average of trailing year earnings per share for each month over a ten year rolling period of time, after adjusting each month's actual or interpolated trailing year earnings figure for inflation.

And now, aside from being more than a pain to calculate, the P/E10 ratio is apparently indicating that stock prices have reached their long-term average, suggesting that they're now fully valued and that if stock prices continue rising higher, they'll be over-valued. Via King, Jason Zweig writes in the Wall Street Journal:

Stocks have suddenly become more expensive to accumulate. Since March, according to data from Robert Shiller of Yale, the price/earnings ratio of the S&P 500 index has jumped from 13.1 to 15.5. That's the sharpest, fastest rise in almost a quarter-century. (As Graham suggested, Prof. Shiller uses a 10-year average P/E ratio, adjusted for inflation.)

Over the course of 10 weeks, stocks have moved from the edge of the bargain bin to the full-price rack. So, unless you are retired and living off your investments, you shouldn't be celebrating, you should be worrying.

Really? Should you? And what kind of advice is that, anyway? If you're retired and living off your investments, shouldn't you be the most concerned that they're overvalued?

S&P 500 with P/E10 Ratio, 1871-2009 Source: Doug Short What if we told you that we know for an absolute certainty that the dreaded P/E10 ratio is going to rise higher than the chart to the left (HT: Doug Short) says it is today. A lot higher. Your stocks will be totally overvalued by this measure, quite possibly for the next ten years! Are you through celebrating yet? Are you ready for the stress of ten whole years worth of worrying?

How do we know? Simple! Being practioners of the dark art perhaps best known to the public as "math," we know that there are two ways that we can make any ratio, which are really just fractions, grow really large:

  1. Make the numerator really big.
  2. Make the denominator really small.

While stock prices have risen in recent months, they're pretty much doing exactly what we would expect them to do, so we really can't get all worked up into a rabid lather by being scared by them being "too high." No, we'll instead turn our attention to the denominator and take a closer look at what might be going on there.

Inflation Adjusted Trailing Year Earnings per Share Data, January 1999 to April 2009 As it happens, what's going on there is that the denominator is getting smaller. In fact, it's going to be getting smaller at a lot faster rate than the numerator is likely to grow larger. Why is that? Well, let's consider the period of time that Shiller's ten-year inflation-adjusted earnings per share is spanning as it has risen and fallen over the past ten years, which includes:

  1. The back side of the Dot-Com Bubble, during which the S&P 500's inflation-adjusted earnings per share rose from $51.54 in May 1999 to $65.98 in September 2000.
  2. Falling with the 2000-01 recession to $29.48 in March 2002.
  3. Rising steadily from that low to $86.98 per share in June 2007.
  4. Then plummeting to an inflation-adjusted $7.23 per share in April 2009.

From these changes, we see that the new earnings per share values that are replacing the older earnings per share values in the calculation of the E10 average are much, much lower. Consequently, the value of the denominator in the E10 calculation is shrinking. And it will continue shrinking, even though we're now well past the event that resulted in earnings having plummeted so far. What's more, those low values will be holding down the average level of inflation-adjusted earnings per share for ten whole years!

And that shrinking denominator means that the P/E10 ratio won't just rise, it will rise well above it's long term average. Really, the only thing that could keep the P/E10 ratio down at reasonable levels given these circumstances is if stock prices rise fall at least as fast, or faster if we want this ratio to drop to a "safe" and "worry-free" level.

But will they? That's unlikely given that CEOs were throwing everything including the kitchen sink into jacking up their bad earnings numbers for the sake of getting as much bad news out at a time when every other CEO was doing the same thing, providing really nice cover from their shareholders.

Either way though, as a Zweig-style panicky investor, the good news would be that the P/E10 ratio would then be low enough to not have to worry about your portfolio being overvalued!

Update: Modified the last three papagraphs to make more mathematic sense. Must. Get. Coffee....

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