To try and squeeze some more performance out of a retirement investing strategy that is heavily focused on asset allocation I am using a cyclically adjusted Price / Average 10 Year Earnings (PE10) ratio for the S&P 500 to value the US (specifically the S&P 500) stock market. The method used is that developed by Yale Professor Robert Shiller. Background information here.
Chart 1 plots the Shiller PE10. Key points this month are:
- Shiller PE10 = 21.0 which is up from 20.6 last month. My UK Equities target asset allocation therefore drops from 18.3% to 18.1%. Additionally my International Equities target asset allocation drops from 13.1% to 12.9%.
- Shiller PE10 Average (1881 to Present) = 16.4
- Shiller PE10 20 Percentile (1881 to Present) = 11.0
- Shiller PE10 80 Percentile (1881 to Present) = 20.6. The Shiller PE10 has now passed through the 80 Percentile.
- Shiller PE10 Correlation with Real (ie after inflation) S&P 500 Price = 0.78
Chart 2 further reinforces why I am using this method. While the R^2 is low there appears to be a trend suggesting that the return in the following year is dependent on the Shiller PE10 value. Using the trend line with a PE10 of 21.0 results in a 1 year expected real (after inflation) earnings projection of 4.4%.
Chart 3 plots Real (after inflation) Earnings and Real Dividends for the S&P 500. Real Dividends are still falling however they are still above their long term trend. Real Earnings have a roller coaster ride continually, particularly since about 1990. If the Standard and Poors forecast earnings are to be believed however we continue to be above the long term earnings trend. These forecasts maybe aren’t so good though with the year getting off to a bad start – profits at Alcoa (the first to report for 2010) down and Chevron also announcing lower fourth quarter profits than forecast.
- Q1 ’09 & Q2 ’10 earnings are estimates from Standard & Poors.
- Inflation data from the Bureau of Labor Statistics. December ‘09 & January ‘10 inflation is extrapolated.
- January ‘10 dividend is estimated as December ‘09 dividend.
- Prices are month averages except January ‘10 which is the 11 January ’10 S&P 500 stock market close.
- Historic data provided from Professor Shiller website.