Why Dow Investors Aren't Panicking Over This Nobel Laureate's Dire Warning

Robert Shiller thinks stocks are overvalued, but does his cyclically adjusted price-to-earnings measure make sense to use?

Jun 25, 2014 at 12:48PM
Longview

Bullish sentiment reasserted itself on Wednesday, as the Dow Jones Industrials (DJINDICES:^DJI) posted a 30-point advance as of 12:45 p.m. EDT. Surprisingly, traders ignored some signs of economic weakness in bouncing back from a larger drop Tuesday, following a pattern that has repeated itself countless times over the course of the 5-year-old bull market. But Nobel Prize-winning economist Robert Shiller sounded an alarm about the high levels of the stock market, suggesting that today's high valuations using his cyclically adjusted price-to-earnings, or CAPE, ratio could point to bad performance for the Dow Jones Industrials in the future.

What the CAPE is saying
The idea behind Shiller's CAPE measure is pretty simple. If you follow standard earnings multiples, they're typically based on a single year's worth of earnings. As a result, earnings can fluctuate dramatically from year to year, making valuations seem to be rising or falling even when the share price stays constant. One particularly good example of this phenomenon from the Dow Jones Industrials is Travelers (NYSE:TRV), which can see particularly volatile swings in earnings depending on whether catastrophic events happen. What the CAPE does is take 10 years of earnings, letting those short-term bumps smooth into a more representative sample encompassing entire business cycles for most industries.

To get a sense of Shiller's worries, take a look at the following chart:

S&P 500 Cyclically Adjusted Price-Earnings Ratio Chart

S&P 500 Cyclically Adjusted Price-Earnings Ratio data by YCharts.

As you can see, the CAPE ratio has climbed back to levels higher than it has seen during almost all of the period over which Shiller has made measurements. Specifically, figures higher than the current CAPE reading have occurred only in the lead-up to the Crash of 1929, the Go-Go Market period of the 1960s, the tech boom of the late 1990s, and the housing boom in the mid-2000s. By that argument, Shiller believes the Dow is in danger of a drop similar to what the market experienced after those previous periods.

The big assumption CAPE makes
In choosing a 10-year period, the CAPE model figures that a decade is long enough to represent a typical series of ups and downs for the economy as a whole. Yet the depth of the financial crisis calls that assumption into question.

In particular, earnings for the S&P 500 (SNPINDEX:^GSPC) during the financial crisis dropped to a degree not seen since the Great Depression:

S&P 500 Earnings Chart

S&P 500 Earnings data by YCharts.

Those who don't believe the CAPE model reflects current overvaluation question whether those earnings declines were consistent with ordinarily cyclical behavior. If they represent a 50-year to 100-year event, as the historical data suggest, then a 10-year CAPE would distort its measure of "cyclical" earnings lower, making the valuation seem higher.

As a result, whether the Dow Jones Industrials are overvalued isn't as clear as Shiller's analysis makes it seem. Moreover, by the end of the 2010s, when the 2008-09 earnings dip is no longer included in the 10-year back-looking period, the CAPE will fall even if stocks hold onto their gains. That doesn't mean that Shiller is wrong that a market pullback could come sooner than later, but it's not the slam-dunk conclusion that you might think based solely on the CAPE ratio's level.

Top dividend stocks for the next decade
The smartest investors know that dividend stocks simply crush their non-dividend-paying counterparts over the long term. That's beyond dispute. They also know that a well-constructed dividend portfolio creates wealth steadily, while still allowing you to sleep like a baby. Knowing how valuable such a portfolio might be, our top analysts put together a report on a group of high-yielding stocks that should be in any income investor's portfolio. To see our free report on these stocks, just click here now.

Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Money to your ears - A great FREE investing resource for you

The best way to get your regular dose of market and money insights is our suite of free podcasts ... what we like to think of as “binge-worthy finance.”

Feb 1, 2016 at 5:03PM

Whether we're in the midst of earnings season or riding out the market's lulls, you want to know the best strategies for your money.

And you'll want to go beyond the hype of screaming TV personalities, fear-mongering ads, and "analysis" from people who might have your email address ... but no track record of success.

In short, you want a voice of reason you can count on.

A 2015 Business Insider article titled, "11 websites to bookmark if you want to get rich," rated The Motley Fool as the #1 place online to get smarter about investing.

And one of the easiest, most enjoyable, most valuable ways to get your regular dose of market and money insights is our suite of free podcasts ... what we like to think of as "binge-worthy finance."

Whether you make it part of your daily commute or you save up and listen to a handful of episodes for your 50-mile bike rides or long soaks in a bubble bath (or both!), the podcasts make sense of your money.

And unlike so many who want to make the subjects of personal finance and investing complicated and scary, our podcasts are clear, insightful, and (yes, it's true) fun.

Our free suite of podcasts

Motley Fool Money features a team of our analysts discussing the week's top business and investing stories, interviews, and an inside look at the stocks on our radar. The show is also heard weekly on dozens of radio stations across the country.

The hosts of Motley Fool Answers challenge the conventional wisdom on life's biggest financial issues to reveal what you really need to know to make smart money moves.

David Gardner, co-founder of The Motley Fool, is among the most respected and trusted sources on investing. And he's the host of Rule Breaker Investing, in which he shares his insights into today's most innovative and disruptive companies ... and how to profit from them.

Market Foolery is our daily look at stocks in the news, as well as the top business and investing stories.

And Industry Focus offers a deeper dive into a specific industry and the stories making headlines. Healthcare, technology, energy, consumer goods, and other industries take turns in the spotlight.

They're all informative, entertaining, and eminently listenable. Rule Breaker Investing and Answers are timeless, so it's worth going back to and listening from the very start; the other three are focused more on today's events, so listen to the most recent first.

All are available for free at www.fool.com/podcasts.

If you're looking for a friendly voice ... with great advice on how to make the most of your money ... from a business with a lengthy track record of success ... in clear, compelling language ... I encourage you to give a listen to our free podcasts.

Head to www.fool.com/podcasts, give them a spin, and you can subscribe there (at iTunes, Stitcher, or our other partners) if you want to receive them regularly.

It's money to your ears.

 


Compare Brokers