Thursday 7 March 2013

The S&P 500 Cyclically Adjusted PE (aka S&P 500 or Shiller PE10 or CAPE) – March 2013 Update

With the mainstream media this week reporting new nominal highs for the Dow Jones Industrial Average lets also run our own regular analysis of the US market to get some detail on what is really going on in this market.   As always instead of the Dow, which only looks at 30 large companies, we’ll turn our attention to the S&P500 which looks at 500 leading public companies.  Last month’s update can be found here.

Before we crunch the numbers it’s worth pointing out that while titles like Asian markets climb after Dow Jones hits record high make for great headlines, I can’t help but feel that this is misleading the general public as they might actually think that the market is at new highs.  Of course regular readers will know that Dow isn’t at a new Real (inflation adjusted) high, but only at Nominal highs, as the unit of measure that the Dow and S&P500 is measured in, the US Dollar, is constantly being devalued through inflation.  When it comes to the S&P500, the Real high was way back in 2000 and we are still some 22.5% below that level.  

Let’s now look at the key S&P 500 metrics:
  • The S&P 500 Price is currently 1,543 which is a rise of 2.0% on last month’s Price of 1,512 and 11.1% above this time last year’s monthly Price of 1,389.
  • The S&P 500 Dividend Yield is currently 2.0%.
  • The S&P As Reported Earnings (using a combination of actual and estimated earnings) are currently $89.63 for an Earnings Yield of 5.8%.
  • The S&P 500 P/E Ratio is currently 17.2 which is up from last month’s 17.0.

The first chart below provides a historic view of the Real (inflation adjusted) S&P 500 Price and the S&P 500 P/E.  The second chart below provides a historic view of the Real (after inflation) Earnings and Real (after inflation) Dividends for the S&P 500.

Chart of the S&P500 Cyclically Adjusted PE, S&P500 PE and Real S&P500
Click to enlarge

Chart of Real S&P500 Earnings and Real S&P500 Dividends
Click to enlarge

Let us now turn our attention to the metric that this post is interested in which is the S&P500 Cyclically Adjusted PE (S&P 500 CAPE), also known as the Shiller PE10.  This is also shown in the first chart which dates back to 1881 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. 

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.

The key S&P 500 CAPE/PE10 metrics are:
  • The S&P 500 PE 10 is currently 22.4 which is 1.1% above last month’s 22.2.
  • The correlation between the Nominal S&P500 Price and the S&P 500 PE10 from present day back to 1881 is 0.66.  This is considered a moderate, bordering on strong correlation and is one reason why I use this metric to make investment decisions from.
  • The Dataset Average S&P 500 PE10 which dates back to 1881 is 16.5.  Assuming this is “fair value” it indicates that the S&P500 is now some 36% overvalued.
  • The Dataset Median S&P PE10 is 15.9.
  • The Dataset 20th Percentile S&P 500 PE10 is 11.1.
  • The Dataset 80th Percentile S&P 500 PE10 is 20.9.

The chart below further highlights why I use the Shiller PE10 to drive a tactical portion of my Retirement Investing Today asset allocation which is stacked 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 March 2008.  The correlation is -0.46 with an R^2 of 0.21.  This implies that there is a moderate correlation between the S&P 500 PE10 and future returns from the market.  With the PE10 at 22.4 the trendline implies a person buying today could expect a future Nominal 5 Year Total Return of around 34%.  In contrast the Real (inflation adjusted) 5 Year Total Return (not shown in any chart today) trendline implies a return of 21%.

Chart of the S&P500 versus the 5 Year Total S&P500 Return
Click to enlarge

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 26.5 (Average PE10+10) or 19.5% should the PE10 fall to 6.5 (Average PE10-10).  Therefore today my tactical allocation sets itself below 15% at 12.3%.

As always do your own research.

Assumptions include:
  • S&P500 Prices are month averages except March 2013 which is a 07 March 2013 mid market Price.
  • January, February and March 2013 Dividends are assumed to be equal to the December 2012 Dividend
  • October 2012 to March 2013 reported earnings are estimates from Standard & Poor’s. 
  • Inflation data from the Bureau of Labor Statistics.  February and March 2013 inflation is extrapolated.
  • Historic data provided from Professor Shiller website.

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