Some of you may already know about economist Robert Shiller, author of Irrational Exuberance. Mr. Shiller has done an incredible amount of research on the stock market, the housing market, and other big issues in the business and finance world. He is pessimistic on today's stock market, read on for further information.
A piece of his work that I really find interesting is a stock market evaluation technique that he came up with. It is quite simple. All you do is take the S&P 500's current share price and divide it by average corporate earnings. If the result is above 20, the market has historically performed poorly in the years after. If the result is below 10, the market has historically performed quite well after that point. At the peak of the tech bubble the result was an astonishing 44, today it is hanging around 17.
This technique keeps you in tune with the support earnings are giving the S&P 500, and to make sure that doesn't slip away. In almost every case of a ratio above 20, it has been during a bull market when people forget about valuation and financials, and go with "the hot thing."
It is something worth keeping an eye on, because it is also a simple way to keep in touch with Benjamin Graham's emphasis on value investing (Shiller's technique has followed the basic idea of Graham's approach to stay away from the stock market when it is "flying high" and everyone is all of a sudden hyped about the stock market) and buying when the market has been hit, or when there is no longer faith in stocks and the stock market.
But that is only one of the many reports that Robert Shiller has put together. His web site gives you access to an incredible amount of research, including an excellent report on the P/E (Dated 7/21/96), of which a brief sample follows:
The simplest and most widely used ratio used to predict the market is the price–earnings ratio. The use of one-year's earnings in the price–earnings ratio is an unfortunate convention, recommended by tradition and convenience rather than any logic. As long ago as 1934, Benjamin Graham and David Dodd, in their now famous textbook Security Analysis, said that for purposes of examining such ratios, one should use an average of earnings of "not less than five years, preferably seven or ten years." (p. 452) Earnings in any one year tend to be affected by short-run considerations, that cannot be expected to continue. In the present time, earnings have suddenly shot up in the last few years, bringing price–earnings ratios down dramatically, but it is doubtful that such sudden changes are meaningful. We extend our moving average even further than Graham and Dodd did, on the supposition that even more smoothing is advantageous, and Graham and Dodd didn't have the data then to make such smoothing possible.
We chose to represent long-horizon returns, of ten years, since that is what really matters to most investors, because there is so much interest today in long-term investing, and because there is recent evidence in the statistical literature that the long-horizon returns are more forecastable. This may be contrary to one's expectations; one might have thought that it is easier to forecast into the near future than into the distant future, but the data contradict such intuition. This forecastability of the market is not the kind of thing that will enable us to forecast that a crash is around the corner; it is forecasting gradual trends, analogous to forecasting the prospects for a city based on population trends, or forecasting the success of a university in terms of the number of young people who are enrolling.
It is some incredible work, and I encourage anyone interested in business, finance, and/or the economy to read some of his research papers. They have been very accurate so far, and most likely will be in the future. For some more information on Robert Shiller and his latest work, take a look at these articles:
Closing Bell: Economic Catapult for Thanksgiving & Black Friday (WMT, TGT, GRMN, GOOG, MSFT)
Deere up on Q4 earnings performance
Reid Hoffman: LinkedIn will go public (at some point)
Reader Comments (Page 1 of 1)
7-27-2006 @ 3:18PM
Web said...
Nice Blog
You state in your blog that the current "shiller" pe is 17. Shiller uses the average 10 year earnings (while accounting for inflation) to arrive at his pe.
http://aida.econ.yale.edu/~shiller/data/ie_data.htm
His website data indicates that as of Jan 2006 the
shiller pe is 26.639 - applying the current long rates, inflation and S&P 500 the current Shiller pe is roughly 25.23. So based on Shiller's PE the market is still overvalued substantially.
The PE of 17 you state is using the current earnings, not the 10 year average earnings - it seems. And shiller's pe is based on the average 10 yr earnings, no?
If you have a chance to review this info, I'd be interested in your views - keep up the good work.
7-27-2006 @ 5:41PM
Karl Hodgson said...
Fundamental analysis is one thing, trading especially short term requires charting techniques for all financial markets.
Candlesticks were invented by Japanese rice traders over 400 years ago and only Samurai were allowed to be traders!
Different charting techniques are the way to trade and understand with a picture what the markets are doing and to predict with a high degree of success the FUTURE.
World markets first require you look at money, (the largest market). Graph the USD, then gold(the ultimate money and inverse to the dollar) Then graph WTIC(contract price for oil)-backs our "petro-dollar". Graph whatever it is you put money on divided by the USD(that's what you are trying to make money on). You can chart anything and see right away what's going on.
Proof that the charts work? Chart the USD and gold right now, and you can see the dollar is on the bottom trendline on a mormally bearish formation. gold is at the top and end of a three month triangle. Tomorrow is the GDP report! There will be a break! VERY EXCITING TIMES!
If you are a novice, go to stockcharts.com, click on public charts, and then look at some of the techs that post their charts free! Read some books on trading(I like Toni Turner's short term trading" but there are others too.)
With a little practice and study the financial world will be yours! You will know more than 99.9% of the other people, you will make money, and become a modern day Samurai! (not literally I hope!)
7-28-2006 @ 4:13PM
David Kretzmann said...
Hi Web,
You are correct, I only used a "current and quick" way to get the Shiller P/E, and didn't add in the other economic factors and historical numbers. Good work for finding it out yourself!
I believe the stock market will be struggling over the next few years for several reasons. First, it is overpriced historically (As Shiller shows us); second, I think with all the trouble in the Middle East we will see some instability with oil prices, which can affect stocks greatly; third, I see a lot of overvalued stocks right now in the ethanol sector, which is getting an amazing amount of public attention. If people realize they are overpaying and start selling, it could put some short-term pressure on the market.
Since I'm not directly invested into the stock market though, I am not worried. I have a nicely diversified portfolio which includes some international stocks, and many different strategies, so I feel that in the long-term my portfolio will do much better than the stock market itself.