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Shiller Index Points to Inflated Stock Prices

| December 04, 2013
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It is the beginning of December 2013 and the S&P 500 index is merely points below the all time high. This index has seen 27% growth over the past year and 101% growth over the last five years. The Dow and Nasdaq indexes are also close to their all time highs. Interest rates are still low, housing has rebounded, the employment rate has dropped and corporate earnings have risen. Those investors who were not scared out of leaving the market in 2008 and 2009 have greatly benefited from this rise.

Nobody, including myself and the advisors of Blue Summit, can predict when the market will reach its peak or when it will hit bottom but it is a measurable fact that the last few years have seen growth and not decline in overall US stock prices. Will this growth continue? That is the ultimate question that everyone wants answered but even amongst the experts (hedge funds, banks, financial advisors) there are different opinions over the future direction of the broad market. While past performance does not indicate future returns we can offer this analysis.

The Shiller PE Ratio is a measure of the current stock market price relative to the past 10 years of earnings. The higher the price (of the entire market) with consistent earnings, the higher this ratio becomes. Last month the inventor of this ratio, Yale professor Robert Shiller, won the Nobel Prize in Economic Science. Right now the Shiller PE ratio, also known as the PE10, is at 24.86 while the mean (from 1880 to present) is at 16.50. Compared to the past we can get an idea of the stage in the cyclical market that may be in right now.

Source: http://www.aqr.com/Portals/1/ResearchPapers/ShillerPECommentary_AQRCliffAsness.pdf

As you can see in the above chart we are in the second to highest category of PE10 Ratios, and very close to the highest. The third column shows the average return over the next 10 years when starting an investment in the historical PE10 category. As the returns are inversely correlated with the beginning PE we expect the probability of a market correction is higher in the current high PE10 environment. Right now the PE10 is in the category with an average expected return of 0.9% annualized over the next 10 years. Of course we have not always landed on the average, the best return from this starting point has reached 8.3% and the lowest us -4.4% but again we are focused on the most likely scenario and by this measure we are looking at less than 1%, the average.

An additional look at the historic Shiller PE ratio from 1880 to present (Mean=red line):

Source: http://www.multpl.com/shiller-pe/

There are many other ways to measure the market and many other views on the future as I mentioned above. For example, billionaire buy and hold investor Rob Baron believes the market will continue to rise. Looking back beyond the trough of 2008 Baron compares our current valuations with those of 2007, and even farther back to 1999. Instead of looking at where we have come from the bottom he compares the current environment to prior periods of market growth and sees additional upside potential. If the Federal Reserve maintains a policy of near zero interest rates Baron does not foresee a slowdown in the short term and he has close to $24 billion in assets under management from investors who believe in his theory.

There are many approaches to money management and, while it’s true that we cannot predict the future, it is important to base portfolio allocations on sound research. While the Shiller PE ratio may suggest that stocks are historically expensive right now, investors must factor in their portfolio income needs, time horizon, taxes, overall estate plan, and other competing life goals and investment objectives to determine their appropriate asset allocation. We can help you by creating unique models and even more specific portfolios with this research in mind and in accordance with your own specific goals. This may mean a steady course with equities, bonds, and real estate for families and individuals who have withdraw needs greater than five years from now or an increased cash position for shorter time horizons. Every client situation is different and we would be happy to discuss your individual needs and circumstances. Please call us if you would like to schedule a call to review your portfolio allocation.

These views are those of Blue Summit and should not be construed as investment advice. Investors cannot directly invest in indices. Past performance does not guarantee future results. Investments in securities do not offer a fixed rate of return. Principal, yield and/or share price will fluctuate with changes in market conditions and, when sold or redeemed, you may receive more or less than originally invested. No system or financial planning strategy can guarantee a future result. Therefore, no current or prospective client should assume that future performance or any specific investment, investment strategy or product will be profitable. Securities and Advisory Services offered through Cetera Advisors LLC, member FINRA, SIPC. Cetera is under separate ownership from any other named entity.

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