Whilst PE multiples have limited ability to tell us anything about how richly or poorly valued a security is, especially for companies who consistently compound earnings over long periods of time, they weren’t particularly useful in valuing cyclical companies in the developed world either. This is because the PE would be understated as earnings rise at the peak of the cycle and vice versa. Robert Shiller, a Nobel price winning economist took care of this by defining a ‘Cyclically Adjusted PE’ or CAPE or now known as the Shiller PE, where instead of using a single year’s earnings for the denominator, a ten year average is used. This gauge is now suggesting a massive overvaluation for the S&P500. “July’s reading of 37.98 is more than double the average, and the highest since the dot-com bubble.”
But Shiller himself reckons this ratio is also limited to the extent that it doesn’t capture the interest rate environment we are in.
“Shiller himself has moved onto a different metric, called the excess CAPE yield, which considers both equity valuation and interest-rate levels. It’s defined as difference between the inverted CAPE ratio and the 10-year inflation-adjusted interest rate.
…As the chart shows — and remember, since we’re looking at yield, low numbers imply higher valuations — current valuations aren’t outrageous.”
But this isn’t particularly foolproof either and naturally, could change if interest rates were to rise:
“…“a fundamental problem with the low rates argument –– that we may be comparing one overvalued asset class with another.”
Now much has been made about what could move yields higher, but hot inflation readings lasting for longer than the Federal Reserve expects would be the likely catalyst.
Put another way, if real rates rise to where they stood at the end of 2018, Shiller’s new valuation measure would move to 2007 territory — right before the global financial crisis.”
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