Robert Shiller Voices Concerns Over Current Valuations

The topic of the day from a short-term perspective is the state of the geopolitical issues in Ukraine/Russia and to a lesser extent Iraq and Gaza/Israel.

The way this game is played is simple, really. When headlines speak of troop movements, stocks go down. Then when the news wire reports that tensions have eased (as was the case Monday morning), stocks go up.

Most importantly, it is vital to remember that once the geopolitical issue that captured the market's attention for a spell is over, oftentimes so too is the corrective phase brought on by the bad news.

Will the news that Ukraine and Russia have come to some sort of agreement on the convoy of humanitarian aid mean that traders and their fancy trading machines will soon turn their attention to something else?

Will the easing of tensions mean another round of new highs for the major stock indices?

Time will tell, of course, but things were looking up around the globe on Monday morning.

Related Link: Are Stocks Really Overvalued?

The Bigger Picture Concern - Valuations

However, from a longer-term perspective, the current level of stock market valuations is quickly becoming a topic of interest among analysts. Therefore, we will continue the thorough review of valuation indicators -- something that could take a week or two to complete.

In fact, Nobel-Prize winner Robert Shiller wrote a piece in this weekend's New York Times suggesting that stocks "look very expensive right now" and that investors should be worried.

In the article, Shiller wrote, "The CAPE ratio, a stock-price measure I helped develop -- is hovering at a worrisome level...nothing I've come up with is a slam-dunk explanation for the continuing high level of valuations. I suspect that the real answers lie largely in the realm of sociology and social psychology -- in phenomena like irrational exuberance, which, eventually, has always faded before. If the mood changes again, stock market investments may disappoint us."

The CAPE Ratio

In case you are not aware, Shiller's CAPE ratio -- the cyclically adjusted price-to-earnings ratio -- is a long-term valuation metric designed to adjust for inflation.

According to Wikipedia, "The cyclically adjusted price-to-earnings ratio, commonly known as CAPE, Shiller P/E, or P/E 10 ratio, is a valuation measure usually applied to broad equity markets. It is defined as price divided by the average of 10 years of earnings (Moving average), adjusted for inflation."

In addition to Shiller's own warning that his CAPE Ratio is worrisome right, a handful of analysts, including Ned Davis, have also noted that the CAPE is currently flashing a warning.

Before we continue with the analysis, there is one important caveat to provide in relation to the CAPE. In Shiller's own words, "The CAPE was never intended to indicate exactly when to buy and to sell. The market could remain at these valuations for years." In fact, Shiller penned a piece for the times more than a year ago noting that the CAPE Ratio had reached worrisome levels.

Are Investors Sailing Into Cape Fear?

The key point to Shiller's weekend article in the NYT is that the CAPE Ratio is currently above the 25.5 level. There are two reasons why this may be noteworthy from a long-term perspective.

Related Link: 5 Reasons The Market Correction Is Long Overdue

First, according to Shiller, the average reading for the CAPE Ratio since 1900 has been... survey says... 15.21. The low end of the range has been about 5.0, a level that was seen in the early 1920s and 1930s. In more recent times, the low seen in 1982 was near 7.0 and the low in 2008 was about 13.0.

In looking at more than a century of data, the high end of the range for the CAPE prior to the 1990s had been the extreme move seen in the roaring 1920s. If one excludes the spike to 34 during that period, the high-water mark was more like 23-25 until the mid-1990s

The second key point that Shiller makes is that the CAPE Ratio has only been higher than the current level three other times in history: 1929, 2000 and 2007.

History shows that in all three prior instances, the stock market moved higher BEFORE a bear market ensued. But... the bear markets the followed such lofty levels of the CAPE were some of the nastiest on record.

For example, in the 1928 example, the S&P 500 SPY moved higher for nearly a year before succumbing to the Crash of 1929. In 1996, stocks moved higher for more than two years before the technology bubble bear began. In the 2007 example, the market moved higher for 45 months after the CAPE first reached the worrisome levels.

In addition, it is worth noting that since 1995, the CAPE ratio has spent the majority if the time either at or below 25.

The Key Takeaway

In short, Shiller's main point is this: "...we should recognize that we are in an unusual period, and that it's time to ask some serious questions about it."

The next missive will explore several more variations on the P/E ratio as well as several other valuation indicators in order to get a good feel for the data on the subject.