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Chuck Carnevale
Chuck Carnevale
Articles (279)  | Author's Website |

Shiller PE Continues to Mislead Investors, the S&P 500 Is Fairly Valued in Early 2013

January 15, 2013 | About:

Allow me to start this article by emphatically stating that I have a real problem with forecasting stock markets in the general sense. Instead, I prefer to forecast the intrinsic values of individual businesses based on their earnings justified fundamental values. I hold this position because I believe that it is not only possible, but also quite practical to analyze a specific business and then make an intelligent forecast (not a guess) but a rational estimation, based on the assimilation of fundamental facts, as to its past, present and future intrinsic value. Importantly, I’m not suggesting this can be done with absolute perfect precision down to the precise penny. Rather, I am suggesting it can be done within a reasonable range of rational probabilities.

In contrast, trying to estimate the collective results of a large group of companies such as the S&P 500 (SPY) is a very daunting task. There are just too many variables and too many data points to contemplate from which to make a rational and/or reasonably accurate forecast. On the other hand, the evidence I’ve reviewed suggests that the earnings and price correlation and relationship is just as valid on an index as it is on an individual stock. In other words, earnings will be the primary driver of stock price for both a specific company and an index.

With the above said, I have been periodically posting articles relating to the valuation of the S&P 500 based on the earnings and price-correlated fundamentals analyzer software tool F.A.S.T. Graphs™. My rationale for engaging in an activity that I generally eschew is born of my desire to help people be better informed investors. To me, this means injecting more fact-based information into our analysis and less opinion. Facts provide information that can be quantified and evaluated. Opinions, on the other hand, are often emotionally charged, which can lead to irrational responses and behaviors. Therefore, I feel that the emotional response does not belong in something as important as making prudent investing decisions. Reason should dictate behavior rather than emotions such as fear or greed.

Allow me to try to clarify this a little more by presenting the current earnings and price-correlated F.A.S.T. Graphs™ on the S&P 500 since calendar year 1993. The orange line on the graph plots earnings per share at the historical normal PE ratio of 15. The reader should note that the blue line on the graph represents a historically normal PE ratio of 19 over this time period. This simply indicates that for much of this time frame, the S&P 500’s stock price was in overvalued territory. Importantly, notice how the stock price tracked the orange earnings-justified valuation line, and that whenever it deviated away from the line it inevitably moves back towards alignment. Today, with a blended PE ratio of 14.8 the S&P 500 is reasonably valued. (Note: because of the long duration of this graph, only every other year is typed in, although data for all years is plotted.)


At this point, it’s important to state that historical F.A.S.T. Graphs™ valuation measurements are based on actual S&P 500 operating earnings as reported, and estimated earnings (numbers marked with E for estimate) come directly from the Standard & Poor’s website. This is in contrast to the very popular statistical S&P 500 valuations based on the Shiller PE ratio calculation known as CAPE which utilizes earnings calculated as a 10-year average. If you carefully study the earnings- and price-correlating graph above, it is obvious that earnings for the S&P 500 (the orange line) have mostly advanced with the exception of the two recessions of 2001 and 2008.

This is important because mathematically speaking the 10-year average of an advancing number will most often calculate earnings to be lower than they actually are. Of course, the exception would be when you’re calculating a 10-year average during a recessionary period when earnings have fallen. The point is that the only way that the Prof. Shiller statistical calculation can be correct is if future earnings fall. Again, an average of 10 years' worth of increasing numbers will, mathematically speaking, always be lower than the current number. However, the problem is that as the graphic clearly indicates, earnings of the S&P 500 increase much more often than they fall. This clearly, at least, has been true for the last couple of decades.

This creates a problem for investors that I find appalling. For the great majority of the time, the Shiller calculated PE ratio will generally indicate that the market is overvalued. Consequently, investors who buy into this thesis will generally tend to avoid investing in stocks. Yet, if they were to calculate valuation based on actual numbers, they would more often than not find that stocks are fairly priced to even cheap, instead of overvalued. Therefore, they are often avoiding stocks at precisely times when the risk of investing in them is lowest, and simultaneously, when the rewards for owning them are highest.

To further illustrate my point, here is an article published on Oct. 12, 2011, where real earnings data indicated that the S&P 500 was cheap with a PE ratio of 12.6 based on the then-estimated earnings for the S&P 500 for 2011 of $97.98. Actual 2011 earnings came in slightly lower at $96.44 (1.6% lower than originally estimated), but still represented a 15% advance over 2010. Consequently, the S&P 500 was still trading at a PE ratio below 13, and less than its historical normal PE of 15. Unfortunately, the Shiller PE for the S&P 500 was at 20.15. Since anything over 16 is considered expensive, CAPE was declaring that the S&P 500 was overvalued, not undervalued.

The following earnings and price correlated graph shows the S&P 500 at a price of 1194.89 on October 10, 2011. As of this writing, the S&P 500 is priced at 1472.05 or approximately 23% higher than it was in October of 2011. Therefore, investors believing in the Shiller statistical PE missed out on a great buying opportunity.


In the spirit of accountability, the following are links to several other similar articles to this one, utilizing the actual PE of the S&P 500 based on real earnings and the near estimate of future earnings. For perspective, I’ve reported the date the article was published and the respective Shiller PE ratio on that date. Once again remember that according to Prof. Shiller, his statistically calculated PE ratio has to be approximately 16 or lower for fair value to exist. All of the following examples show that the Prof. Shiller CAPE (Cyclically Adjusted PE) would have caused investors to avoid investing in equities when the opportunities in doing so were high, and the risks based on valuation low.

When this article was written on Jan. 6, 2010, the Shiller S&P 500 PE was 20.52 indicating overvaluation. The F.A.S.T. Graphs™ that calculated PE on actual earnings of 19.1 agreed.

However, by Feb. 21, 2010, when I published this next article, the Shiller S&P 500 PE was 19.91, still indicating overvaluation. However, it is interesting to note that earnings forecasts for both 2008 and 2009 ended up being lower than the actual results.

Then on Nov. 2, 2010, I published an update suggesting that the S&P 500 should reach 1254 by year-end based on estimated earnings; the Shiller S&P 500 PE was 21.69, continuing to say that the market was overvalued.

When I published the next article on Dec. 23, 2010 the Shiller S&P 500 PE of 22.39 was still indicating overvaluation. But as actual earnings were higher, the S&P 500 target of 1254 was reached.

By Jan. 9, 2011, I published this article when the Shiller S&P 500 PE 22.97 continued to suggest overvaluation even though the Index continued to make above-average returns for those investors with the foresight to focus on actual earnings rather than a statistical representation.

When I published an article on April 7, 2011 the Shiller S&P 500 PE of 23.05 continued to relentlessly suggest overvaluation. Nevertheless, the market has advanced approximately another 10%, from 1333 to 1472, since that time. Yet all of the gains were achieved during times when the Shiller PE was suggesting that stocks were overvalued.

Since the beginning of 2010 when the first article I cited above on the valuation of the S&P 500 was published, the S&P 500 has produced a compounded annualized rate of return of 11.6% (including dividends), while all the while, the Shiller PE was screaming overvaluation. In contrast, the valuation based on the actual earnings of the S&P 500 suggested reasonable valuation. The following performance results since Dec. 31, 2009, illustrate what investors, afraid of owning common stocks, missed out on.


This is why I prefer decisions based on facts over decisions based on artificial constructs and mere statistical representations such as CAPE. Perhaps if you keep yelling that the sky is falling long enough, it may one day occur. However, where I sit, it appears that that may be a long way off. Therefore, I much prefer serious analysis based on the facts that I do some hypothetical estimation based on what can be very misleading statistics.

A Fair and Balanced View

However, and in order to be fair and balanced with this article, the following F.A.S.T. Graphs™ looks at the S&P 500 since Jan. 1, 2009, when the Shiller PE ratio was at 15.17 indicating undervaluation. From this picture, it is clear that both real operating earnings and the CAPE (Shiller’s Cyclically Adjusted PE) both indicated fair value. However, it’s important to recognize that this was a time when the S&P 500’s earnings had actually fallen from $87.72 in calendar year 2006 to $49.51 by 2008. In other words, the Shiller CAPE was accurate because it was measured at a time when S&P 500 earnings had fallen for two consecutive years in a row, and just prior to strong S&P 500 accelerating earnings growth coming off of the low base.


Consequently, the S&P 500 performance when the Shiller PE ratio was at 15.17, indicating a solid buy, was exceptional. However, it was also during a time when the S&P 500 was moderately overvalued based on actual earnings, and just prior to the strong earnings advance previously mentioned and illustrated.


A Few Words About Specifics Versus Generalities

As I indicated in my opening remarks, I prefer analyzing individual companies over attempting to forecast the earnings of a broad market like the S&P 500. One of my primary reasons for believing this is that my research has suggested that in every market, whether bull or bear, there can always be found overpriced, underpriced or fairly priced individual selections among the group. Therefore, I believe in making specific decisions rather than general ones.

Since a picture is worth 1000 words, I am going to present earnings and price correlated graphs on the following three well-known S&P 500 stocks to illustrate my point. I will let the graphs speak for themselves and offer only this brief explanation. When the price is above the orange earnings justified valuation line, the stock is overvalued, when below the line, undervalued, and when on the line (or very close to it), fairly valued. Therefore, I offer Home Depot (NYSE:HD) as an overvalued S&P 500 company, Johnson & Johnson (NYSE:JNJ) as a fairly valued example, and finally Aflac (NYSE:AFL) as an undervalued company.





With a blended PE ratio of 15, I believe the S&P 500 is fairly valued based on real current and near forecast earnings. My optimism rests on the idea that the world economy is improving coming out of the great recession, and that we will soon see significant productivity enhancements as the deployment phase of the information revolution comes into high gear. Moreover, I believe that high-profile blue-chip publicly traded U.S. companies are well-positioned for profitable long-term growth. The great recession of 2008 forced many of them to take long hard looks at their balance sheets and P&L’s. As a result, I believe corporate America is leaner and meaner, so to speak, than it has been in a long time. Consequently, productivity enhancements should feed its bottom lines.

In the Oct. 5, 2012 edition, Trends Magazine published an article titled, The Truth About Stocks.”A few select excerpts from the article both summarize and highlight my optimistic views:

On the Market’s Long-term Record

“Since 1912, the inflation-adjusted total return for investments in common stocks has averaged 6.6 percent per year, compounded. That’s 100 years of solid performance despite numerous surges and crashes.

Any way you slice it, it’s an impressive record.

But, after more than 12 years of minimal price appreciation and weak dividend performance, many investors find themselves asking the question, “Will we ever see 6.6 percent average annual returns again?”

On Future Earnings Growth

“As soon as 2014, we’ll begin to see rapid economic growth return; the exact timing will depend on policy factors that are hard to predict. Houses will begin to move, demand for autos will grow, and sales will pick up in retail stores. As a result, corporate profits will grow at a renewed pace, which will drive up stock prices. As long as long-term interest rates move up, improved investor confidence will eliminate much of the pervasive “worry deficit” that’s held down “relative P/E ratios” for a decade. Another factor contributing to equity returns will be demographics: Domestically, solid birth rates plus immigration will create demand for more goods and services. Although it’s true that Europe and Japan will remain stagnant due in large measure to aging and declining populations, this will be more than offset by The $30 Trillion-a-Year Opportunity of 2025 discussed later in this issue.”

On the Sources of Growth

“Second, in the coming decade, total returns on stocks should actually exceed historic norms, as the Deployment phase of the global Information Revolution takes off.

This phase will drive the biggest boom in world history, providing the “productivity miracle” Bill Gross could evidently not imagine happening. This boom will materialize for a number of reasons. Here are a few:

This is the first time that over 5 billion people living in the developed world will take part in this type of revolution; previous revolutions have been limited to the developed world.

New technologies will make low-cost energy available in enormous quantities.

The combination of infotech, biotech and nanotech will dramatically increase the amount of GDP that can be produced per unit of matter and energy, eliminating much of the traditional drag created by resource shortages.

Increasingly, the most valuable resource will become information, which can be made available to almost anyone, anywhere, at any time for free once it is created. “

The bottom line to my thesis is that I expect future earnings of the S&P 500 to be higher than they are today, not lower, as the Shiller PE would want you to believe. On an absolute basis, in other words, on actual current earnings, I believe the S&P 500 is fairly priced. In my experience, when the markets in general are fairly priced, it is easier to find fairly priced individual selections than it would be if the market were truly overvalued. Furthermore, like all markets there are overpriced stocks in the general market, I shared an example with Home Depot above. Nevertheless, there is plenty of value to be found for the discerning investor willing to dig deep enough.


I believe there is no substitute for making intelligent decisions based on factual information. Having an intelligent framework with which to make investing decisions can eliminate mistakes that are too often made when emotion is overtaking reason. Within this process, I believe it’s important to recognize that over the vast majority of the time, positives outweigh negative. Therefore, it’s important to realize that negative economic cycles such as recessions only come rarely, and usually end rather quickly. So, I suggest that instead of being traumatized and frightened away, it’s worth considering that the best times to be looking at equities is when times are tough. Because, it is during these times when great businesses go on sale.

Disclosure: Long HD, JNJ and AFL.

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

About the author:

Chuck Carnevale
Charles (Chuck) C. Carnevale is the creator of F.A.S.T. Graphs™. Chuck is also co-founder of an investment management firm. He has been working in the securities industry since 1970: He has been a Partner with a private NYSE member firm, the President of a NASD firm, Vice President and Regional Marketing Director for a major AMEX-listed company, and an Associate Vice President and Investment Consulting Services Coordinator for a major NYSE member firm.

Prior to forming his own investment firm, he was a partner in a 30-year-old established registered investment advisory in Tampa, Florida. Chuck holds a Bachelor of Science in economics and finance from the University of Tampa. He is a sought-after public speaker who is very passionate about spreading the critical message of prudence in money management. Chuck is a veteran of the Vietnam War and was awarded both the Bronze Star and the Vietnam Honor Medal.

Visit Chuck Carnevale's Website

Rating: 3.4/5 (12 votes)


Vitaliy premium member - 4 years ago
Chuck, you are partially right but your conclusion is wrong. Over last 100+ years 10 year trailing P/E was higher than average 1 year trailing P/E. Average 10 year P/E was 18 and average 1 year trailing P/E was 15. Your reasoning why it was higher is right. As economy grows earnings grow and therefore average E over a 10 year period will (in general) be lower than average E over a 1 year period. So yes, comparing 10 year and 1 year P/Es is not unlike comparing apples and oranges.

But I don't really know anyone who compares 10 year and 1 year P/Es. Any point on 10 year P/E spectrum should be compared to the 10 year mean. For instance, today stocks are trading at 24x 10 year earnings, they are trading at 32% above average (of 18x). See slides 15-17 on this presentation http://contrarianedge.com/2013/01/04/sideways-markets-presentation/

Hopefully this helped. Vitaliy

Royi premium member - 4 years ago
Chuck - A lot of good points come from your article. One thing I want to add is that there is another positive factor of longing stocks: 10-year bond rate is very low - at 1.83% as of 1/15/13. Bond rate / interest rate is part of Ben Graham's formula to calculate intrinsic value in his Intelligent Investor book. A lot of forces are in the bond market now because of the fear of risks in equity market and that is the reason why the bond rate is so low. But these forces will come out of bond markets when the stock market moves higher.
Dirt2624 premium member - 4 years ago

It would be nice to know when earnings are way above trend such as now. Just a reversion to trend would make Chuck's model read a lot differently. Earnings are the least reliable valuation metric available.
Gurufocus premium member - 4 years ago
Thank you for the comments!
JUDS1234567 - 4 years ago    Report SPAM
While it is important to review stocks bottom up, I would agree with Howard marks that macro does matter. Plenty of methods different from the Shiller P.E. label stocks as expensive such as Tobin Q, Crestmon P.E., Buffett GDP/Market Cap, and Hussman Price to Peak.The SP500 Index in its entirety has underperformed T-Bills since 1998 or so.

And to encourage investors to take position in a mature bull market such as this seems rather brave or foolhardy. The market does matter as gyrations will offer better prices for prospective investment. The following from Hussman funds says it all:

"It's important to emphasize that standard bear market declines have historically produced losses averaging about 30% - generally not just 20% (15% declines don't even qualify). I don't expect the next one to be a significant exception… Suffice it to say that the only reason to buy stocks here is a) the belief that one can sell them to a greater fool at higher prices despite already overvalued, overbought, overbullish and rising yield conditions, or b) the belief that the stock market will soar 30-50% from these levels, without experiencing even a minimal bear market in the next 4-5 years" -Although this was written at the peak in 2007 he clearly implies this for the current investment environment.

JUDS1234567 - 4 years ago    Report SPAM
Forgot to add Jeremy Grantham 7 year forecast which has proven to be very robust also labels stocks as expensive. Tough High quality offers above inflation returns.
JUDS1234567 - 4 years ago    Report SPAM

I am glad you took a look at the rebuttal. I will give it my best shot - In defense of the Shiller PE 10. You put a lot of emphasis on earnings which of course is understandable. And based on the last recession and the averaging of 10 years we imply a higher Shiller PE 10 in the future which is of course true. Another argument which is also made is that prices track earnings over time(the market not individual companies as their earnings can re reasonably forecasted). However this can be misleading. I borrowed heavily from Shillers Book here irrational exuberance.

I will use this example in the 1990s for fidelity investments add, Peter lynch was quoted as saying:

“Despite 9 recessions since WWII, the stock market is up 63 fold because earnings are up 54 fold. Earnings drive the market”

This ad right before the peak of the market appears to be designed to sell fidelity mutual funds by convincing readers that price growth is approximately justified by earnings growth. Like now, these numbers are deceptive when long intervals are chosen with no inflation correction and using low earning RIGHT after WWII (Post 2009). Furthermore, if we use other examples we see price changes lead by earnings growth area less justified. Lynch statement as well as the ones implied here are indicative of a common view that stock price changes are generally justified by earnings changes and that this proves that stock market price movements are not due to irrational behavior on the part of investors.

Let’s dive deep into some examples. The first great bull market 1920-29 was a period of rapid earning growth real SP earnings tripled over that period yet prices actually increased seven fold- an overreaction indeed.

The second great bull market the correspondence between price and earnings growth is not so clear either most of the price growth occurred in the 1950s and from 1950 to 1959 the index tripled BUT earning only grew 16% in total over that decade. Below average by historical standards.

For example in 1982 to 2000 prices rose continuously but earnings grew unevenly. Real SP earnings were actually lower at the bottom of the 1991 recession than the 1982 bottom! But the real SP 500 index was of course two and a half times as high! So I would say that for this current bull market prices cannot be viewed as a simple reaction to earnings increase. Price earnings growth and price growth do not correspond well at all. In fact price movements tend to be large relative to earnings and price swings relative to the long trend earnings have tended historically to be reversed later. Now I am refereeing to the market here, as you point out individual stocks may be another matter. None the less I use the Shiller PE as a rough proximate for an exposure to equities.

Would it also not be true that as the low or negative years in the PE 10 equation drop off the Shiller PE 10 begins to adjust itself to this new reality?

Either way the evidence is pretty irrefutable in a variety of ways:

1. Price to earnings ratio empirically has been shown to forecast long term returns. Consider Shiller PE Ratios 1901 PE10 at 23 20 years later the market had lost 67% percent of its real value. Real return 5 year later=3.4& with Div. 10 years later =4.4% 15 years later=3.1% and 20 years later= -.2%

2. Consider Shiller PE Ratios 1966 PE10 at 24(same level we are at now). Similar to today there was a surge in earnings and the market stupidly extrapolated these into the future. Real earnings increased little over the next 5 years. 8 years later the market had lost 56% percent of its real value. Get this real prices would not reach thir 1965 high until 1992! Real return 5 year later=-2.6& with Div. 10 years later =-1.8% 20 years later=1.9%

3. The Q ratio which endorsed by Andrew Smithers does not even factor smoothed earnings into the equation yet reached the same conclusion of overvaluation. In fact this was very promising as both methods arrived at the same agreement with empirical evidence thus validating each other.

You quote

“Generally, earnings grow except for the occasional recession. Therefore, the analysts forecasting growth tend to be mostly correct, even if their exact factor is off. Furthermore, both 9% and 14 % would indicate approximately the same fair value calculation. However, they would represent different long term returns, but not fair value.”

I take great issue with this. This is the great disconnect as Jeremy Grantham, John Hussman and even Warren buffet have pointed out. No normalization of profit margins for the market as a whole, which based on your previous comments you do not endorse. David Dreman also take great point with analyst estimates as they have so many errors and discrepancies too numerous to mention here. Read contrarian investment strategies.

Another quote in your resonse also caught my notice “To repeat my possession, the only way that CAPE can be correct is if future earnings are lower than today” A very dangerous assumption.

Hussman : Notice that elevated profit margins are also strongly mean-reverting over the economic cycle. In general, elevated profit margins are associated with weak profit growth over the following 4-year period. The historical norm for corporate profits is about 6% of GDP. The present level is about 70% above that, and can be expected to be followed by a contraction in corporate profits over the coming 4-year period, at a roughly 12% annual rate. This will be a surprise. It should not be a surprise. Here is the punch line. Any normalization in the sum of government and household savings is likely to be associated with a remarkably deep decline in corporate earnings.

As I noted a few weeks ago, it would be one thing if the reason for presently elevated profit margins was even a mystery. But there is no mystery here. Wall Street is grossly overestimating the value of stocks based on profit margins that are 70% above the historical norm. The expansion of profit margins is the mirror image of the plunge in government and household savings in recent years.

Stocks are not cheap. Forward operating P/E ratios – indeed, any metric that does not adjust for the elevated position of profit margins – are presenting a wildly misleading picture of market valuation. Recognize the reasons for this now, or discover the consequences of this later.

(Which of course would make the Shiller PE absolutely right- not your occasional recession)

Buffett in regards to the market in 1999 with elevated margins above 6% LIKE NOW:

“In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%... Maybe you’d like to argue a different case. Fair enough. But give me your assumptions. The Tinker Bell approach – clap if you believe – just won’t cut it.”

[i]- Warren Buffett, “Mr. Buffett on the Stock Market,” Fortune Magazine 11/22/99

In 1999, Buffett correctly recognized the overvaluation of the market - and the weak basis for investors' assumptions to the contrary - when he noted that “you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%.” As should be fully evident from both accounting identities and historical data, the fact that corporate profits are now 70% above their historical norms can be directly attributed to the extraordinary deviation of government and household savings from their own historical norms. –Hussman

Grantham: “PE without normalization mean nothing” –Morningstar Investment Conference 2010 I believe

Again no insult to Mr. Carnavale, but the Shiller PE does not mislead investors. However I do agree with individual bargains in stocks being found. None the less I am not invested at the moment since I would rather have the wind at my back with lower valuations in the future.

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