Friday, February 27, 2009

The 10-year PE ratio

One good valuation technique is the 10-year PE ratio. That is the current real price of the S&P 500 divided by the average of the last 10 years of real earnings per share. This is better than the trailing twelve month PE since it smooths over periods of excessive profitability or un-profitability. The following chart (from Robert Shiller's data) shows this ratio back to the 1880s. The red line shows the median value 15.68 and the blue line is at 10 which appear to be around where the troughs occur. Some were worse than this for example in 1921. Right now we are at 12.95 (S&P 500 = 745) which is somewhat below average but somewhat higher than most troughs. To reach PE(10)=10, the S&P 500 would fall to 575 or another 23%. To reach the lowest ever PE(10)=4.78, it would drop to 275 or another 63%. Lets hope that doesn't happen.

There is another way to look at this however. It is possible that the inflation correction is incorrect. There is an alternative inflation measure which claims to be closer to what was used for most of US history. This is from Shadowstats . The Shadowstats inflation measure is much higher than the government reported inflation rate, especially for the past few years. The following plot is the same as above but with the alternative Shadowstats CPI inflation correction applied to both earnings and price. The effect of this is that it makes stocks look cheaper since the correction to the current price is larger than the correction to 10-year earnings.

Which is correct if any? I don't know but would guess that the best measure is probably somewhere in between.

Conclusions: stocks are probably approaching their lows and buying solid blue chip companies is likely the right thing to do. Certainly, selling now look like the wrong thing to do.