Sunday 24 June 2012

The S&P 500 Cyclically Adjusted PE (aka S&P 500 or Shiller PE10 or CAPE) – June 2012 Update

The S&P 500 closed on Friday at 1,335.  By my calculations I also have as Reported Earnings (using a combination of actual and estimated earnings) at \$92.33.  Combining these two pieces of data gives us an S&P 500 P/E Ratio of 14.5.

While interesting, for my own investment purposes, I do not use the P/E ratio.  Instead I use what I have called the Shiller PE10 which is shown in my first chart (effectively an S&P 500 cyclically adjusted PE or CAPE for short).  This method is used and was made famous by Professor Robert Shiller.  It is simply the ratio of Real (ie after inflation) S&P 500 Monthly Prices to 10 Year Real (ie after inflation) Average Earnings.

As always it is important to highlight that my calculation method varies from that of Professor Shiller.  He only uses S&P 500 Actual Earnings data where because I use the S&P 500 PE10 to actually make investment decisions from I also include extrapolated Earnings estimates right up to the present day.  This is to try and make the value as current as possible.

Today the S&P 500 PE10 stands at 20.7 with my first chart showing a plot of its history back to 1881.  This chart also shows the Real (inflation adjusted) S&P 500 price and the S&P P/E over this same period.  A summary of the PE10 data that might be of interest:
-    S&P 500 PE 10 = 20.7.
-    Dataset Average PE10 = 16.4.  Assuming this is “fair value” it indicates that the S&P500 is still some 26% overvalued.
-    Dataset Median PE10 = 15.8.
-    Dataset 20th Percentile = 11.0.
-    Dataset 80th Percentile = 20.9.

My second chart plots Real (after inflation) Earnings and Real Dividends for the S&P 500.  Earnings continue to grow with estimated earnings at an already stated \$92.33.

My third chart today highlights why I use the Shiller PE10 to drive a tactical portion of my Retirement Investing Today asset allocation which is on top of a basic strategic asset allocation.  This shows a chart of the S&P 500 vs the Nominal 5 Year Total Return from January 1881 through to June 2007.  The correlation is -0.46 with an R^2 of 0.21.  This implies that there is a partial correlation between the S&P 500 PE10 and future returns from the market.  With the PE10 at 20.7 the trendline implies a future Nominal 5 Year Total Return of 41%.  In contrast the Real (inflation adjusted) 5 Year Total Return (not shown in any chart today) trendline implies a return of 26%.

So what of my Retirement Investing Today portfolio.  Regular readers will know that I use the above PE10 data to set my allocation to the International Equities portion of my portfolio.  This is strategically set at 15% of total assets and is targeted to consist of 40% US Equities, 40% Europe Equities and 20% Japan Equities.  I then add the S&P500 PE10 tactical spin on top of this with a target of 10.5% allocation should the PE10 climb to 26.4 (Average PE10+10) or 19.5% should the PE10 fall to 6.4 (Average PE10-10).  Therefore today my tactical allocation sets itself below 15% at 13.1%.

As always do your own research.

Assumptions include:
-    Prices are month averages except June ‘12 which is a 22 June ’12 S&P 500 market close price.
-    January ’12 to June ’12 reported earnings are estimates from Standard & Poor’s.
-    Inflation data from the Bureau of Labor Statistics.  June ‘12 inflation is extrapolated.
-    Historic data provided from Professor Shiller website.