The price to earnings (P/E) ratio is a fundamental metric for evaluating whether a particular investment (or markets in the aggregate) are overvalued, undervalued, or fairly valued, with the caveat that the P/E ratio can be highly volatile from year to year and across the business cycle.
As a result, even Graham and Dodd in their classic book “Security Analysis” suggested that a multi-year average of P/E ratios across 5, 7, or 10 years may be helpful to smooth the effects – a recommendation that economists Robert Shiller and John Campbell later enshrined into his “Cyclically Adjusted P/E” (or CAPE) ratio. Yet while Shiller and Campbell found that taking a 10-year average of earnings to formulate the CAPE ratio did have predictive value,
Swedroe points out that there’s nothing particularly sacred about using a 10-year average in particular. For instance, while the CAPE 10 ratio (using 10 years of earnings) puts the market at 57% overvalued (a 26.3 CAPE compared to a 16.7 average), using a CAPE-6 ratio, the market is only 19% overvalued (a 22.7 P/E ratio compared to a long-term average of 19 since 1960), and a CAPE-5 ratio similarly puts it at 18% overvalued (a CAPE 5 of 22.1 compared to a historical average of 18.1 since 1960).
In addition, Swedroe also suggests that the long-term baseline of the CAPE 10 ratio may be flawed, given both changes in FASB accounting rules (particularly regarding the write-off of goodwill, which allows corporations to write off losses more quickly, depressing earnings and making the CAPE ratio appear more elevated), that corporations are more likely in recent years to retain earnings and reinvest them to raise Earnings Per Share (EPS) rather than pay them out as dividends (and different EPS growth rates can support different CAPE ratios), and that investors may be more tolerant of higher of higher CAPE ratios now because markets are more liquid and investors demand less of a liquidity premium. Ultimately, all these adjustments might still lead to a conclusion that the markets are at least slightly overvalued at current levels, but Swedroe suggests that the 57% overvaluation
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