It becomes clearer every day that the stock market does not follow a random walk and that there may be some predictability in long-term returns. But there's little agreement on how best to make such predictions. In this article, I'll take a look at using price/earnings ratios to predict future stock market performance.
In the late 1990's, Yale professor Robert Shiller used P/E's to warn about the overvalued stock market. His concerns were based on a method of measuring price/earnings ratios he had been working with since the early 1980's. The method goes back to work by Graham and Dodd and measures the price of a broad stock market measure, like the S&P 500, in relation to the past 10 years of average earnings. The reason for using 10 years is to smooth out (or “normalize”) the effects of business cycles. Shiller also adjusts his measures for inflation by translating both prices and earnings into consistent "real" numbers before doing the ratio calculations. You can access the Shiller data here.
When we look at the past 15 years (referring to Table 1 below), it is worth paying particular attention to two time periods.
Table 1 -Ă‚ Recent History of Annual Shiller P/E's
• In 1996, Shiller expressed concerns that the stock market was becoming significantly overvalued. At that time the Shiller P/E had risen to 24, compared to a long term average of around 17. In December of that year, Alan Greenspan, influenced by Shiller’s work, made his famous "Irrational Exuberance" speech. Despite these warnings, the stock market kept going up, and the Shiller P/E rose to an all-time high of 43 in 2000 before the dot-com bubble finally burst.Â
While the Shiller P/E may be a good predictor of long-term stock market performance, it has never been touted as a predictor of market turns.
During the recovery from the bursting of the dot-com bubble, many of us were comforted that, although stocks were rising, they were just working their way back from depressed values. However, when we look at the Shiller P/E's, we note that the post-bubble P/E’s never dropped down even to average levels. Stocks basically went from ridiculously overvalued to significantly overvalued. In various writings and television appearances in 2006 and 2007, Shiller indicated that he felt stocks were still overvalued.
When we look further back into history, we can see that Shiller P/E's have been excellent predictors of subsequent 10-year stock market performance. High P/E's (over 20) have invariably predicted poor stock market performance. With the benefit of hindsight, the all-time high P/E levels of the late 1990's virtually screamed "lost decade ahead!"Ă‚ (See Table 2 and the graph below)
Table 2 - Shiller P/E's and Average Stock Retur
Joseph A. Tomlinson, FSA, CFP
Guest Contributor of
http://www.advisorperspectives.com/
In the late 1990's, Yale professor Robert Shiller used P/E's to warn about the overvalued stock market. His concerns were based on a method of measuring price/earnings ratios he had been working with since the early 1980's. The method goes back to work by Graham and Dodd and measures the price of a broad stock market measure, like the S&P 500, in relation to the past 10 years of average earnings. The reason for using 10 years is to smooth out (or “normalize”) the effects of business cycles. Shiller also adjusts his measures for inflation by translating both prices and earnings into consistent "real" numbers before doing the ratio calculations. You can access the Shiller data here.
When we look at the past 15 years (referring to Table 1 below), it is worth paying particular attention to two time periods.
Table 1 -Ă‚ Recent History of Annual Shiller P/E's
| Beginning of Year | Shiller P/E |
| 1994 | 21.5 |
| 1995 | 20.0 |
| 1996 | 24.3 |
| 1997 | 27.5 |
| 1998 | 32.3 |
| 1999 | 40.4 |
| 2000 | 42.5 |
| 2001 | 36.0 |
| 2002 | 30.1 |
| 2003 | 22.9 |
| 2004 | 25.7 |
| 2005 | 26.5 |
| 2006 | 25.4 |
| 2007 | 26.3 |
| 2008 | 24.0 |
| 2009 | 15.3 |
Average 1928-2009 | 17.4 |
High 1928-2009 (2000) | 42.5 |
Low 1928-2009 (1982) | 7.4 |
Current Value (8/18/09) | 17.7 |
• In 1996, Shiller expressed concerns that the stock market was becoming significantly overvalued. At that time the Shiller P/E had risen to 24, compared to a long term average of around 17. In December of that year, Alan Greenspan, influenced by Shiller’s work, made his famous "Irrational Exuberance" speech. Despite these warnings, the stock market kept going up, and the Shiller P/E rose to an all-time high of 43 in 2000 before the dot-com bubble finally burst.Â
While the Shiller P/E may be a good predictor of long-term stock market performance, it has never been touted as a predictor of market turns.
During the recovery from the bursting of the dot-com bubble, many of us were comforted that, although stocks were rising, they were just working their way back from depressed values. However, when we look at the Shiller P/E's, we note that the post-bubble P/E’s never dropped down even to average levels. Stocks basically went from ridiculously overvalued to significantly overvalued. In various writings and television appearances in 2006 and 2007, Shiller indicated that he felt stocks were still overvalued.
When we look further back into history, we can see that Shiller P/E's have been excellent predictors of subsequent 10-year stock market performance. High P/E's (over 20) have invariably predicted poor stock market performance. With the benefit of hindsight, the all-time high P/E levels of the late 1990's virtually screamed "lost decade ahead!"Ă‚ (See Table 2 and the graph below)
Table 2 - Shiller P/E's and Average Stock Retur
| Period | Beginning of Period Shiller P/E | Average Stock Return |
| 1929-1938 | 26.7 | 3.55% |
| 1939-1948 | 16.2 | 7.70% |
| 1949-1958 | 9.9 | 21.56% |
| 1959-1968 | 18.0 | 10.63% |
| 1969-1978 | 20.8 | 4.84% |
| 1979-1988 | 9.2 | 16.65% |
| 1989-1998 | 15.1 | 19.86% |
| 1999-2008 | 40.4 | 0.65% |
| Average 1928-2008 | 17.4 | 11.09% |
Joseph A. Tomlinson, FSA, CFP
Guest Contributor of
http://www.advisorperspectives.com/
