“Stocks are cheap!” “Stocks are expensive!” It’s one of the oldest debates on Wall Street—and an especially good way to divide investors into competing camps as the U.S. bull market soldiers on in its seventh year.
Each side needs evidence for its arguments, of course, which leads us to competing versions of the price-earnings ratio. The more mainstream metric simply divides the level of an index by the past year’s earnings per share for member companies. A more complex measure of how rich stocks are getting divides the index level by average earnings over 10 years. Yale University economics professor Robert Shiller calls this the CAPE ratio, which stands for cyclically adjusted price-earnings. Others simply call this 10-year version the Shiller P/E for the man who made it famous—the author of the book Irrational Exuberance, which came out in 2000 after an exuberant period that pushed the CAPE ratio to an all-time high.
The difference in methodology may sound minor, but the rival approaches yield drastically different results—especially now, after a decade that includes an economic crisis that decimated earnings. The Standard & Poor’s 500 Index P/E is about 19, based on the E for the past year. The index’s Shiller P/E is almost 27.
What to make of Shiller’s CAPE ratio is controversial—even among supporters. A report earlier this year from Russell Investments says it shows that the market is “outright expensive” versus a long-term average of 16. Investor Jeremy Grantham, co-founder and chief investment strategist at Grantham, Mayo, Van Otterloo & Co. in Boston, says one should look at the CAPE ratio’s average value of 24 since 1987. (That’s when Alan Greenspan became U.S. Federal Reserve chairman, a marker Grantham uses as the start of the current era for stocks.) So the U.S. market’s not at bubble levels yet, according to Grantham. At a conference this week, he said markets are “creeping slowly towards a bubble” and U.S. large-cap stocks are likely to underperform for the next seven years.
Money manager Laszlo Birinyi prefers the one-year P/E. The CAPE ratio has never flashed a clear buy signal, he says, not even in 2009, at the end of the last bear market, when it was still above its long-term average. “At the threshold of a market which to date has gained 200-plus percent, it was a less than inspiring message,” he wrote in March.
Can Shiller himself settle this debate? Nope. He sort of shrugs and throws up his hands. He says the ratio that bears his name has made the market look expensive for a while, spurring some pundits to give pretty bad advice.
Record-low interest rates around the world are rendering some long-held financial theories useless, he says.
“I’ve been very wary about advising people to pull out of the market even though my CAPE ratio is at one of the highest levels ever in history,” Shiller told Bloomberg in April. “Something funny is going on. History is always coming up with new puzzles.”
This story appears in the July/August special Rivalry Issue of Bloomberg Markets magazine.