Methodologies for Determining the Value of Stocks Long-Term

In our recent updates, we have talked about whether or not the stock market was getting too expensive and if we thought it was due for a correction. We have looked at lots of data and charts that seem to indicate that the market is on the high side of its historical valuation. Today, we wanted to share another increasingly popular data point with you. It’s called the CAPE ratio, which stands for the Cyclically Adjusted Price to Earnings ratio.

The CAPE ratio was developed by Robert Shiller, a Nobel Prize winning, economics professor at Yale University. It is a way to measure the Price to Earnings ratio of the stock market, but instead of looking at just one year, the CAPE ratio averages out the earnings for the past 10 years. The idea is that earnings for corporations tend to run in cycles so when earnings are high (as they are now), it’s usually a mistake to assume they will just keep going higher. In other words, the theory is that various factors like increased competition, increasing labor costs or just another recession will eventually lead to decreasing profits for corporations – they don’t just go up in a steady, straight line.

In our January newsletter earlier this year, we showed a chart (below) that measures the net profit margins of US corporations going back to 1951:

image002

Source: PhilosophicalEconomics.com

As you can see, this chart shows the net profit margins to be quite high right now, but it also shows how much the average profit margins can fluctuate. They are certainly not stable, and though they can remain elevated for several years, eventually they tend to go lower.

That would seem to lend credibility to Shiller’s CAPE ratio. By looking at earnings over the past 10 years vs. current prices, we get a better picture of how expensive the stock market is and of where the market might be going.

Today, Shiller’s CAPE ratio stands at about 26 X the average earnings of the S&P 500. To give some perspective, Shiller has calculated his CAPE ratio all the way back to 1881 and the only times it has been higher than 26 are in 1929, 2000 and in 2007. In all 3 of those cases, the stock market had some big declines. However, Shiller does not believe this ratio should be used as a timing mechanism. Rather it’s more of an indicator that our future expected returns from the stock market should be lower.

Here is a chart of the Shiller CAPE ratio:

image004

Below is another chart that shows returns for the S&P 500 from 1926 to 2012 using the various Shiller starting points…in other words, they looked at each year and measured the starting Shiller CAPE reading and then calculated the actual S&P 500 returns over the following 10 years:

S&P from different starting shller

Source:  Advisor Perspectives Viewpoint

The chart is basically telling us that the lower the CAPE ratio is at the start of the 10 year period, the higher the average returns are. And the higher the CAPE ratio at the start, the lower the returns have been for the coming decade. This chart was actually made up last year when the CAPE ratio was at about 24, which is why the box is around that line. Today we are actually in the 25.1 to 46.1 range at the bottom as the CAPE ratio is about 26. That means historically at the other times we were in a similar position, the average returns for the S&P 500 for the coming decade were about 0.5% per year. The best was 6.3% per year and the worst being -6.1% per year for the next decade.

In a recent media appearance Mr. Shiller said that this does not mean you should sell everything and wait for a big correction. He said it’s more of a warning to be a little more cautious about the stocks you own and to reduce your return expectations going forward. This data would also suggest that dividend-paying investments might be a good strategy as the overall returns of the S&P 500 over the next 10 years might not even exceed the dividends.