Valuations of U.S. stocks relative to 10-year average earnings may be more of a show of confidence than a cause for concern, according to Salil Mehta, an adjunct professor at Georgetown University.
The CHART OF THE DAY compares what’s known as the cyclically adjusted price-earnings ratio, compiled by Yale University Professor Robert Shiller, with profit figures that Mehta highlighted yesterday on his Statistical Ideas blog. The latter is inverted to ease comparisons.
Mehta’s numbers are based on an analysis of Shiller’s earnings data. They show the previous decade’s biggest drop in annual profit for each year displayed in the chart, which goes back to 1900. The current low point is the 60.5 percent plunge in 2008, during a U.S. recession and financial crisis.
“Unusually depressed values” for past earnings may lead to a ratio that “is ‘forgiven’ or discounted” even though it’s historically high, Mehta wrote. This happens because investors don’t expect a similar plunge in profit any time soon, the New York-based analyst wrote.
Shiller’s ratio, known as CAPE, ended last week at 25.7. The figure was about 55 percent higher than the average since 1881, which is shown in the chart. The ratio has exceeded the average, 16.6, for all but nine months since 1991.
“The CAPE was never intended to indicate exactly when to buy and to sell,” the New Haven, Connecticut-based professor and Nobel Prize winner wrote in an Aug. 16 commentary for the New York Times, in which he said U.S. stocks were expensive. “The market could remain at these valuations for years.”