The Shiller P/E Shows the Stock Market is Overvalued

The Dow Jones Industrial Average (^DJI 0.13%) hit 16,000 again today, and at the moment is staying above that recent milestone. At the same time, the S&P 500 (^GSPC -0.01%) was a sliver above 1,800 around 1:30 p.m. EST. With the Dow and S&P 500 hitting record highs, it's worth checking where the market is and how it got there. The Shiller P/E ratio, a metric popularized by Economics Nobel Prize winner Robert Shiller, is 50% above its long-term average, indicating the market is overvalued.

Shiller P/E
The Shiller P/E ratio, also known as the cyclically adjusted P/E ratio, uses a 10-year average of inflation-adjusted earnings to value the stock market. Historically, the S&P 500's Shiller P/E has averaged 16.5 over the long term.

To calculate the Shiller P/E you need to adjust the past 10 years' earnings for inflation, average them, and divide by the S&P 500 market price. Adjusting earnings for inflation is not difficult but requires some effort. Thankfully, the folks at Multpl.com have done it for you.

Source: Multpl.com

Now just average the 10 years and divide by the S&P 500 market price.

That gives you a Shiller P/E of 25, 50% above the long-term average of 16.5, and the highest the metric has been since December 2007.

Source: Multpl.com

Multiple other methods indicate the stock market is overvalued, including Warren Buffett's favorite stock market indicator. Shiller told The Wall Street Journal that the current level is "a concern." He went on to say that stocks won't be in bubble conditions until the Shiller P/E climbs to 28.8.

Criticism of Shiller P/E
The Shiller P/E has been criticized as backward-looking, and some argue that the 2008-2009 recession was an extraordinary recession. If you assume a "more normal" recession, with 2008 earnings bottoming at 20% of their 2006 peak, meaning 2008 earnings of 76.8, and higher 2007 and 2009 earnings with a subsequent climb to current levels, the Shiller P/E is only 21.

This argument is misguided, however. You cannot reasonably say that the massive losses in 2008 were an aberration if you don't say that the profits before then were also abnormally high. If you want to smooth earnings this way you should also adjust downward the earnings for 2003, 2004, 2005, 2006, and 2007 for the abnormally high profits of those years.

Foolish last word
While I believe the stock market is overvalued, opinions differ.

With the Federal Reserve committed to low interest rates and pumping money into the economy through quantitative easing, who knows how high the market can go. Predicting where the broad market will go in the short term is a game for fools (with a lowercase "f"). Stocks can always get more overvalued. When things get frothy, it's worthwhile to build up some cash on the side for when prices inevitably fall.

The Motley Fool has always taught that Foolish (capital "F") investors don't invest in the broad market. We invest in great companies at good prices, continue to educate ourselves, and hold on to our great companies over the long term. The market will fluctuate (sometimes massively), but great companies will win out over the long run.