Is the Market Currently Over Valued or Under Valued?

The Shiller Price to earnings ratio which uses historical data over the most recent ten years has been accused of being too bearish because of the depth of the 2007-09 recession. That recession had an 88% drop in profits while normally profits drop 15% in a recession. So if the 2007-09 recession was allegedly a fluke that warped the Shiller metrics, what would happen if hypothetically it were modified to assume the recent crash had only a 15% drop in corporate earnings? That would be about 73 percentage points less, amortized over ten years, or about 7% better income.

So if the PE was at 22 in 7-31-2011 then it would be adjusted to 7% less which is 20.5 PE. This is still high. A recent article by Regent Atlantic Capital attempted to criticize the Shiller PE because of the depth of the 2007-909 recession.

Further, the huge drop in corporate income was not a statistical fluke but rather was a reflection of long term structural changes that bears warn about. For example, the ratio of profits to wages and sales are unusually high, implying that profits will come down. Also the last ten years “real” personal income declined by 0.5% annually which means corporations will need to cut their prices and profits in order to sell to a less affluent society. Aging Baby-Boomers need to save more for retirement which means spending less.

Research by Jeremy Grantham and Andrew Smithers suggest that corporate profits may be inflated by roughly 15% annually in the past 20 years due to understatement of depreciation charges. So if Regent Atlantic Capital is right and Smithers are both right, and I’m wrong then the Shiller PE 10 needs to be adjusted by (15% upward for Smithers and 7% down for Regent) = 8% upward from 22 on 7-31-11 to a PE of 23.7. Thus the market is even more over-priced than Shiller PE tells us.

Risk is that Shiller PE 10 can't foresee future macroeconomic crisis

There is still a need in the next several years for housing to go down which will hurt the economy and corporate profits. The Eurozone banking risks are very high and will affect American banks. China’s economy could cool down and then they would reduce their purchases of commodities and developed country manufacturing equipment exports, thus slowing down the world economy.

The world has become used to inappropriate and dangerous economic stimulation by excessive debt in the form of the Greenspan-Bernanke "Put", Fed’s QE2, U.S. mortgages, U.S. Treasury debt, Eurozone lending in the PIIG’s region, China’s banking system, Japanese government debt, and Japan’s banking system. Japan, for example, has still not finished with “extend and pretend” rolling over of bank loans (at zero percent interest with no principal payments) that should have been liquidated 20 years ago. As the false stimulus is withdrawn then the economy will grow more slowly and profits will decrease, making the Shiller PE 10 ratio even higher.

If anything, the Shiller ratio could be too optimistic because in looking at the past ten years it can’t forecast the possibility of a long Japan-style Soft Depression as the world exhausts the possibilities of endlessly increasing its borrowing.

About the author

Don Martin, CFP®

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