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Getting a bullish urge? This valuation measure stands in the way Add to ...

Europe’s debt crisis is settling, China’s economy is accelerating, the U.S. housing market is on the mend, earnings look good, small investors are moving back into stocks and the S&P 500 is nearing a record high. Is there anything left for investors to fear?

Cautious investors can point to one grey cloud: The Shiller P/E.

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The P/E here is the price-to-earnings ratio of the S&P 500. Shiller refers to Robert Shiller, the Yale University economics professor, author of Irrational Exuberance, one of the brains behind the S&P/Case-Shiller home price indexes and a strong advocate for valuing stocks using a cyclically adjusted price-to-earnings ratio – or a 10-year average of inflation-adjusted earnings, rather than earnings for a single year.

This valuation approach has at least one clear advantage: By looking at a decade of earnings history, you get around short-terms bumps and can see how a company has fared during an entire business cycle.

The disadvantage: While the traditional price-to-earnings ratio for the S&P 500 looks reasonable, at about 15, the Shiller P/E suggests that stocks are expensive. Currently, the Shiller P/E is 22.8, well above the historical average of 16.5, for data going back more than 130 years.

That’s high enough to worry John Hussman, of Hussman Funds. He uses the Shiller P/E as one of four market conditions pointing to what looks like a market peak.

“The S&P 500 is similarly overvalued on a wide range of fundamentals, with the notable exception of ‘forward operating earnings’ where Wall Street analysts have baked in expectations for next-year’s profit margins that are about 70 per cent above the historical norm,” he said in this week’s note to clients.

He believes that current valuations are consistent with a near-zero total return for the S&P 500 over the next five years. To get back in line with prospective annual returns of about 10 per cent a year, the S&P 500 would have to fall 40 per cent.

James Hamilton, who writes the Econbrowser blog and is an economics professor at the University of California, San Diego, also turned to the Shiller P/E in his answer to the question: Is this a good time to buy stocks?

Yes, he agrees that the economy is on track to improve in the second half of the year, while interest rates and inflation should remain low.

“All of that should be bullish for stocks,” he said.

However, he suspects that the good news might be priced into the stock market already – and the Shiller P/E provides all the evidence he needs: “In the historical record, you did indeed tend to earn a lower return on stocks if you bought them at a time like today when the P/E is relatively high,” he said.

Follow on Twitter: @dberman_ROB

 

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