Having spent a large proportion of my career prior to joining GMO working at investment banks, I'm well aware of what Andrew Smithers describes as "Stock Broker Economics," the second tenet of which is "The market is always cheap."1 Over the years I've witnessed many attempts by the practitioners of this most dark art to justify why tried and tested measures of valuation are no longer meaningful, or occasionally create new measures of valuation that purport to show the market to be cheap.2
A recent outbreak of precisely this brand of sorcery has surrounded the Shiller P/E (price relative to 10-year moving average earnings adjusted for inflation as shown in Exhibit 1). Wizards range from the seemingly ever optimistic Jeremy Siegel to any number of Wall Street strategists, and even a blogger whose work I generally enjoy.3 Given that one should always look for evidence that may prove one wrong, I've spent some time thinking about the issues they have raised and have summarized my thoughts in this short paper.
One of the criticisms of Shiller's Cyclically Adjusted P/E (CAPE) that I've come across is that it hasn't given a cheap signal in a long time; that is to say that it has not mean reverted of late.
I am, however, less than convinced by this argument. There is nothing contradictory between the predictions based on the Shiller P/E and the returns that we have witnessed. Exhibit 2 shows the simplest way that I can imagine of transforming the Shiller P/E into a forecast return. We simply revert the P/E towards average over the course of the next seven years and then add a constant to reflect growth and income (let's call it 6% for simplicity's sake). It does a pretty reasonable job of capturing realised returns. If anything, it tends to overpredict returns, rather than underpredict them (which is another of the charges levelled by the critics).
I'd actually suggest that the Shiller P/E is quite possibly too optimistic currently (the complete opposite of the critics' claim). This is because 10-year earnings are currently high relative to their trend. Exhibit 3 shows real earnings, their 10-year average, and a trend line fitted through the 10-year average. Real earnings are currently massively above their 10-year average (accounting for the difference between the spot P/E and the Shiller P/E). However, 10- year average earnings are also significantly above their trend, suggesting that earnings have been above average for a prolonged period (more on this a little later).