I have always considered Schiller's ratio to be too simplistic but I cannot put my finger on it. Thanks to Reuters' very own Anatole Kaletsky (previously he was the highly respected economics editor/columnist for The Times), the explanation for debunking Schiller's ratio is utterly complete. This of course in now way suggests that the present markets globally is NOT overvalued - that is a separate subject altogether.
Kaletsky's arguments are highly worthwhile to read and re read again as there are plenty of investing nuggets, and ways to look at the same thing called investments and shares.
The most celebrated proponent of this view is Robert Shiller, the Nobel Prize-winning, Yale University economist who is often credited with predicting both the 2000 stock market crash and the bursting of the U.S. housing bubble. Shiller may or may not have deserved a Nobel Prize for his academic work on behavioral economics but as a practical guide to investing, his approach has been thoroughly refuted by real-world experience.
Shiller’s status as an investment guru owes much to the timing of his book “Irrational Exuberance,” published just days before the collapse of Internet and technology stocks in March 2000. What is less widely advertised, however, is that for decades, both before and after that predictive triumph, the stock market strategy implied by his analysis has turned out to be plain wrong.
Shiller’s argument that stock prices have been inflated to irrational levels is centered on a statistic called the cyclical adjusted price-earnings ratio, or the Shiller price-earnings ratio. Conventional price-earnings ratios divide the current level of share prices by the earnings estimated by analysts for the year ahead.
This ratio for the Standard & Poor’s 500 is now around 17. On this basis many conventional analysts, including Federal Reserve economists, conclude that U.S. stock prices are reasonably valued. A price-earnings ratio of 17 implies that if companies can sustain this level of profitability, they will provide investors with annual earnings of one-17th, or 5.9 percent, which compares favorably with long-term interest rates on government bonds of around 1 percent, after adjusting for inflation.
Shiller’s price-earnings ratio, by contrast, divides the current level of stock prices by their average profits over the past 10 years (after indexing for inflation). To judge whether stock valuations are reasonable, Shiller compares them not with the prevailing level of interest rates, but with the long-term average of the Shiller ratio.
Viewed against this yardstick, Wall Street share prices look grossly overvalued. The Shiller ratio on the S&P 500 is now 26.3, far above the long-term average of 16.1, calculated by Shiller’s painstaking research on the profits of leading U.S. businesses since the late 19th century. The implication is that Wall Street is grossly overvalued and that investors should prepare for a loss of at least the 40 percent retreat required to return the ratio to 16.
In fact, the expected fall from today’s vertiginous price level should logically be much bigger than 40 percent. For the definition of an average requires that a long period of prices far above average must be balanced by an equally long period of deeply under-valued stocks.
Why then are investors not panicking? There are many theoretical objections to the Shiller’s approach. His arbitrary 10-year averaging takes no account of the length and depth of business cycles and makes no allowance for accounting write-offs. The Shiller price-earnings ratio will continue to be upwardly biased until 2019 because of the longest recession in U.S. history and the biggest-ever corporate write-offs then suffered by U.S. banks.
Even more damning is Shiller’s failure to adjust earnings for accounting changes and the impact of inflation on inventory valuations, distortions that greatly exaggerated profits in the 1970s and produced understated price-earnings ratios.
The most fundamental objection embraces all these technical arguments: Any comparison of valuations covering long periods is meaningless if it fails to take into account vast changes in technology, economic policies, interest rates, social and political structures, and taxes. Why, after all, should the returns expected today on Wall Street bear any relationship to what investors earned in the agricultural booms and busts of the 1880s or the Great Depression of the 1930s or the great inflation of the 1970s?
But leaving aside the theoretical arguments, what about the practical usefulness of the Shiller ratio as an investment tool? Recent evidence is conclusive: For the past 25 years, the Shiller ratio’s signals have been almost uniformly wrong. Since 1989, the S&P 500 has multiplied eightfold, while total returns, including dividends, have increased the value of an average equity investment 12 fold.
Investors who followed Shiller’s methodology, however, would have missed out on almost all these gains. For the Shiller price-earning ratio showed the stock market to be overvalued 97 percent of the time during these 25 years. Even during the two brief periods when the Shiller ratio was below its long-term average — in early 1990 and from November 2008 to April 200 — it never sent a clear buy signal.
Instead, Shiller’s approach suggested that the valuations in 1990 and 2009 were only just below fair value — implying there was very limited upside at the beginning of two great bull markets that saw prices multiply fivefold from 1990 to 2000, and threefold from 2009 to 2014 (so far).
The Shiller ratio’s predictive performance would have been just as bad in earlier decades if it had existed. During the equity bull market of the 1950s and 1960s, for example, the ratio would have said Wall Street was overvalued for 96 percent of the 19-year period stretching from early 1955 to late 1973.
Only in January 1974 did the Shiller price-earnings ratio move below what was then its long-run average, implying it might finally be a “safe” time to buy stocks. Straight after the Shiller ratio sent this first “buy signal” in almost two decades, Wall Street crashed by 40 percent in 12 months.
Time will tell whether the new Wall Street records are evidence of irrational exuberance or simply a reasonable response to gradual economic recovery, as suggested by Federal Reserve Chairman Janet Yellen (correctly in my view).
But one piece of evidence we can safely ignore in making this judgment is the Shiller price-earnings ratio.