A Few Words About Valuation: Ritholtz Chart

Barry Ritholtz is a Bloomberg View columnist. He founded Ritholtz Wealth Management and was chief executive and director of equity research at FusionIQ, a quantitative research firm. He blogs at the Big Picture and is the author of “Bailout Nation: How Greed and Easy Money Corrupted Wall Street and Shook the World Economy.”
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A few weeks ago, Yale Professor Robert Shillerwon the Nobel prize for his work on irrationality and inefficiency of markets. Since then, we have been treated to a plethora of stories on some of his other work -- especially so-called CAPE, Shiller's measure of long term valuation. The general consensus seems to be that CAPE -- the cyclically adjusted price-to-earnings ratio - is elevated, stocks are overvalued, and a crash is imminent.

This is a misreading of both valuation measures, as well as causes of crashes.

CAPE looks at the prior 10 years of trailing earnings. It smooths out any given quarters' ups and downs, and theoretically includes a full business cycle. The way Shiller intended it to be used was to create a valuation metric that would suggest whether stocks are likely to outperform their average returns over the next 10 years.

Shiller's CAPE does this well. As Mebane Faber of Cambria Investment Management observed, when CAPE measures are under 10, forward 10-year returns are outstanding. Over the long run, returns fall the higher CAPE rises. However, over the short run, it is anyone's guess. The range of returns when CAPE is elevated is fairly broad. Indeed, CAPE has been over 20 for the past few years, and U.S .equity returns have been strong.

Source: Mebane Faber

The problem we run into is that valuation is not a timing tool. A momentum trader will tell you from personal experience that overpriced stocks can and do get more expensive. Value investors will tell you from their personal experience that cheap stocks can get a whole lot cheaper.

Mean reversion does not occur immediately after an asset moves away from its long-term trend. Any bond trader can tell you that from their personal experience of the past 30 years.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Barry L Ritholtz at britholtz3@bloomberg.net