Monday, 17 May 2010

US (S&P 500) stock market including the cyclically adjusted price earnings ratio (PE10 or CAPE) – May 2010 Update

To try and squeeze some more performance out of a retirement investing strategy that is heavily focused on buy & hold and asset allocation I am using a Cyclically Adjusted Price / Average 10 Year Earnings (PE10 or CAPE) 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 however I also incorporate earnings estimates up to the PE10 month of interest. Background information here.

Chart 1 plots the Shiller PE10. Key points this month are:

Shiller PE10 = 20.6 which is down from 21.7 last month. My UK Equities target asset allocation therefore increases from 17.7% to 18.3% (nominal based on buy & hold would be 21%). Additionally my International Equities target asset allocation increases from 12.6% to 13.1% (nominal based on buy & hold would be 15%).

Shiller PE10 Average (1881 to Present) = 16.4. This means we are currently 26% (down from 32% last month) higher than the long run average since 1881.

Shiller PE10 20 Percentile (1881 to Present) = 11.0

Shiller PE10 80 Percentile (1881 to Present) = 20.6. The Shiller PE10 is therefore sitting right on 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 20.6 results in a 1 year expected real (after inflation) earnings projection of 4.8%.

Chart 3 plots Real (after inflation) Earnings and Real Dividends for the S&P 500. Real Dividends continue their falls and are now below their long term exponential trendline. Currently though my dividend data points are based on 2 months of estimates. Real Earnings have a roller coaster ride continually, particularly since about 1990. However, if the Standard and Poors forecast earnings are to be believed we continue to be above the long term earnings exponential trend line and still climbing over the coming months.

Assumptions include:
- Prices are month averages except May ‘10 which is the 14 April ’10 S&P 500 stock market close price of 1135.68.
- Jan ’10 to May ’10 reported earnings are estimates from Standard & Poors. 2010 earnings are estimated $65.37 and extrapolated for all months of interest.
- Inflation data from the Bureau of Labor Statistics. May ‘10 inflation is extrapolated.
- April and May ‘10 dividends are estimated as the March ‘10 dividend.
- Historic data provided from Professor Shiller website.

As always do your own research.

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