Dean Baker, in a recent post at the Center For Economic And Policy Research, tries desperately to dismantle an argument over stock valuations and the potential of an asset price bubble. The basis of his argument, that effectively this time is indeed different, utilizes Robert Shiller’s Cyclically Adjusted P/E Ratio and a rather selective bit of data mining. To wit:
“In the last two decades the stock market has twice hit the 25 PE ratio according to Shiller. The first time was in 1997, when Shiller puts the year-end ratio at 27.5. The average real return over the subsequent five years was -0.7 percent. That’s not great, but not exactly a disaster either. Furthermore, the story would look considerably different if we started from the point where the ratio just crossed 25. Shiller puts the 10-year PE at 24.3 at the end of 1996. The average real rate of return for the subsequent five years from that point forward were 8.9 percent. Not much grounds for shedding tears.
The next time the PE crossed the 25 threshold was in 2004 when it hit 27.0. Shiller’s data show the real rate of return in the subsequent five years was 1.1 percent. That’s not fantastic, but it’s probably better than you would have gotten in a money market fund and certainly a hell of a lot better than the negative 12 percent of which Leonhardt warns.
In other words, the last two times the market has crossed this magic 25 PE, investors would have been wrong if they expected a prolonged period of negative real returns. And, since these are the only two times it has crossed this threshold in the last 80 years, we might feel some comfort in using this experience as a basis for expectations of the future.”
In my opinion, this analysis misses some key points.
First, as investors we are supposed to be investing for the “long term.” Mr. Baker’s argument is based on 5 year returns following valuations exceeding 25x earnings. Why not 10 years which would correspond with Shiller’s data? Or 15 years, which is the average amount of time individuals save and invest for retirement?
David Leonhardt recently penned:
“The classic 1934 textbook ‘Security Analysis’ – by Benjamin Graham, a mentor to Warren Buffett, and David Dodd – urged investors to compare stock prices to earnings over ‘not less than five years, preferably seven or ten years.’ Ten years is enough time for the economy to go in and out of recession. It’s enough time for faddish theories about new paradigms to come and go.
Mr. Shiller picked up the Graham-Dodd thread and has long published on his web site a version of the price-earnings ratio that compares current stock prices to average annual earnings over the last decade. He shared the Nobel Prize in economics last year for “empirical analysis of asset prices.â€
