Swedroe: This Metric In Dire Need Of Context

July 14, 2017

With the Shiller CAPE 10 near 30 (29.7 as I write this), it’s likely you have been reading articles that quote gurus who claim the market is on its last legs/breath due to excessive valuations. And the amount of calls I’m getting from concerned investors (especially, it seems, those who hold a certain set of political beliefs) has increased, along with the alarm bells.

But these concerned calls are nothing new. For example, back in February 2013, in his quarterly newsletter, Jeremy Grantham, a respected market strategist at GMO, wrote that “all global assets are once again becoming overpriced” and that some securities were “brutally overpriced.” At the time, the CAPE 10 stood at about 22.

Grantham was far from alone. Here’s another example. John Hussman runs the Hussman family of mutual funds. He’s also a former professor of economics and international finance at the University of Michigan, and has a Ph.D.

Here’s what he had to say in January 2013: “Present overvalued, overbought, overbullish, rising-yield conditions fall within a tiny percentage of market history that is associated with dismal market outcomes, on average. It’s true that we’ve observed extreme conditions since about March 2012 with little resolution aside from short-term declines. But the S&P 500 remains only a few percent from its March 2012 high, and if history is any guide, the extension of these unfavorable conditions is not likely to reduce the depth of the market loss that can be expected to resolve them.”

Ignoring Grantham, Hussman, Marc Faber (Dr. Doom) and many other naysayers, from 2013 through 2016, the S&P 500 Index provided a 14.3% annualized return, well above its historical return since 1926 of 10%. And in the first half of this year, it returned a further 9.3%, bringing its total return since Jan. 1, 2013 to 80%.

Is The Market Overvalued?

Of course, forecasts predicting a bear market will eventually be proven right. As the saying goes, even broken clocks are right twice a day. In fact, bear markets are about as inevitable as the bull markets that precede and follow them.

This brings us to the question of whether the markets are really overvalued. To answer it, we’ll examine current valuations provided by J.P. Morgan Asset Management in its Third Quarter (2017) Guide to the Markets.



While the forward-looking price-to-earnings (P/E) ratio is higher than the 25-year average, it’s not that much higher (9.4% relatively higher). And it’s only “overvalued” by 0.5 of a standard deviation. The dividend yield is actually a bit higher than the 20-year average, while the price-to-book (P/B) ratio is identical with its long-term average.

However, though not shown in the table, the index’s price-to-cash flow ratio was 12.2 versus the 25-year average of 10.6, putting it 0.8 of a standard deviation “overvalued.”


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