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The Case-Shiller CAPE Is Obsolete (At Least for Now)

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Is another bubble forming in stocks?

Are stocks cheap right now? Are they expensive?

While these are fundamental questions that serious investors should know the answer to, I'd venture a guess that few have more than a vague sense of the market's present valuation. And this issue has only gotten worse over the past few years, as the primary metric for measuring the broader market's earnings multiple has become obsolete for all intents and purposes.

The metric I'm referring to is the Case-Shiller cyclically adjusted price-to-earnings ratio, or CAPE, which takes a 10-year rolling average of the S&P 500's (SNPINDEX: ^GSPC  ) P/E ratio.

Now, don't get me wrong. The work that Professors Shiller and Case did to put this dataset together should be applauded (to say nothing of their invaluable collection of historical home prices), as it's the most complete and widely available measure of long-term stock valuations that I've come across.

The problem with it, however, is that the rolling average is currently being distorted by an outlier:

See that massive spike in the red line? That's the S&P 500's actual P/E ratio for the first three quarters of 2009 -- that is, the quarters immediately following the financial crisis of September 2008.

What happened, pray tell, during those quarters? Earnings tanked, particularly for any company that happened to be in the financial, automobile, or housing industries (at least those that were lucky enough to survive).

Take DR Horton (NYSE: DHI  ) , one of the largest homebuilders in the country. It lost a staggering $2.6 billion in 2008 and an additional $550 million in 2009. Or how about Bank of America (NYSE: BAC  ) , the nation's largest bank measured by deposits. Its diluted net income was a negative $2.2 billion in 2009, compared with a positive $21 billion in 2006.

While these distortions have worked their way through the contemporaneous data, their presence lingers in the Case-Shiller rolling average. It's for this reason, in turn, that the current CAPE overstates the S&P 500's actual valuation by nearly 38%.

What's the point? The point is twofold. In the first case, while I believe that stocks are indeed overvalued right now (click here to read why), they aren't as high as this widely cited metric would lead one to believe. And in the second case, this should serve as a reminder that there's sometimes more to data than meets the eye.

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Bank of America CAPS Rating: ****
DHI $30.20 Up +0.06 +0.20%
D.R. Horton CAPS Rating: ***