Monday, 5 July 2010

US (S&P 500) stock market including the cyclically adjusted price earnings ratio (PE10 or CAPE) – June 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 = 18.6 which is down from 20.6 at my last update. My UK Equities target asset allocation therefore increases from 18.3% to 19.6% (nominal based on buy & hold would be 21%). Additionally my International Equities target asset allocation increases from 13.1% to 13.9% (nominal based on buy & hold would be 15%). This is based on my tactical asset allocation described in this series of posts here mandating that I hold 30% less stocks when the S&P500 PE10 = 26.4 and that I own 30% more stocks when the S&P 500 PE10 = 6.4. This is centred on fair value being a PE10 of 16.4.

Shiller PE10 Average (1881 to Present) = 16.4. This means we are currently 14% (down from 26% at my last update) 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 has therefore now fallen 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 18.6 results in a 1 year expected real (after inflation) earnings projection of 6.2%.

Chart 3 plots Real (after inflation) Earnings and Real Dividends for the S&P 500. Real Dividends are now close to the long run trend line. Real Earnings have a roller coaster ride continually but the forecasts from S&P suggest earnings rising well above the long term trend line. Are the forecasters being too optimistic? Only time will tell.

As always do your own research.

Assumptions include:
- Prices are month averages except June ‘10 which is the 02 July ’10 S&P 500 stock market close price of 1022.58.
- April ’10 to June ’10 reported earnings are estimates from Standard & Poors. S&P has June 2010 earnings estimated at $63.57 and I have extrapolated the other months of interest.
- Inflation data from the Bureau of Labor Statistics. June ‘10 inflation is extrapolated.
- April to June ‘10 dividends are estimated as the March ‘10 dividend.
- Historic data provided from Professor Shiller website.

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