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Professor Bob Shiller on using his ratio


merkhet
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http://online.wsj.com/articles/robert-shiller-on-what-to-watch-in-this-wild-market-1412972484

 

Known as the “cyclically adjusted price/earnings ratio,” or CAPE, Prof. Shiller’s measure is based on the current market price of the S&P 500-stock index, divided by its average earnings over the past 10 years, both adjusted for inflation. It stands at nearly 26, well above the long-term average of about 16.

 

If only things were that simple, Prof. Shiller says.

 

“The market is supposed to estimate the value of earnings,” he explains, “but the value of the earnings depends on people’s perception of what they can sell it again for” to other investors. So the long-term average is “highly psychological,” he says. “You can’t derive what it should be.”

 

Even though the CAPE measure looks back to 1871, using data that predates the S&P 500, it is unstable. Over the 30 years ending in 1910, CAPE averaged 17; over the next three decades, 12.7; over the 30 years after that, 15.7. For the past three decades it has averaged 23.4.

 

Today’s level “might be high relative to history,” Prof. Shiller says, “but how do we know that history hasn’t changed?”

 

So, he says, CAPE “has more probability of predicting actual declines or dramatic increases” when the measure is at an “extreme high or extreme low.”

 

For instance, CAPE exceeded 32 in September 1929, right before the Great Crash, and 44 in December 1999, just before the technology bubble burst. And it sank below 7 in the summer of 1982, on the eve of a 17-year bull market.

 

Today’s level, Prof. Shiller argues, isn’t extreme enough to justify a strong conclusion. So, he says, he and his wife still have about 50% of their portfolio in stocks.

 

Seems pretty similar to Buffett's discussions about a zone of reasonableness.

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It hovered around 25-27 from part of 2003-2007 - which is where we are right now. I'm more concerned with Buffett's market cap to gnp ratio. We're at a higher point now than anytime in higher - except 2000. I've been toning down my risk throughout the year.

 

 

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http://www.multpl.com/s-p-500-earnings/table

Isn't 2008-09 skewing things a bit?

 

Also notice how earnings barely grew after world war 2, while economy went through quite a large boom? S&P is after all largest companies. Could it be that all those companies eat up other companies? For example half your health products are now sold by one company. Seems like you did not have nearly as much of those huge conglomerates in the past.

This graph shows that nicely:

 

http://www.convergencealimentaire.info/map.jpg

 

So it could be there are now more companies in the S&P 500 because of this. Because didn't the whole conglomerate trend kinda start in the 70's somewhere?

 

Another reason could be industries moving towards rational oligopoly type structures? So more earnings.

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It hovered around 25-27 from part of 2003-2007 - which is where we are right now. I'm more concerned with Buffett's market cap to gnp ratio. We're at a higher point now than anytime in higher - except 2000. I've been toning down my risk throughout the year.

 

Oddly enough, Buffett talked about this ratio in his recent interview with Carol Loomis. He had a similar reaction to Shiller. It is useful in extremes, but we aren't in a clear extreme right now.

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