I love it when we beat the NY Times to a story! This Sunday’s article Dueling Prisms for Valuing Stocks discusses many of the issues surrounding current stock market valuation that I brought to your attention in last week’s TWM Client Letter, Q4 Market Valuation Update — The Air is Thinner Up Here.
The article presents a debate between Jeremy Siegel, a Wharton finance professor, and Robert Shiller who originally wrote about the 10-year PE ratio in his book, Irrational Exuberance. Siegel agrees with the idea of smoothing earnings over time (which is the way TWM calculates the PE ratio for use in deciding whether to rebalance portfolios) because it reduces distortions in 1-year data that can mislead investors about market valuation. However, Siegel believes that the current 10-yr PE ratio is itself distorted because it includes two major earnings recessions (the tech wreck and the financial crisis) and, therefore, he thinks that stocks are more attractively valued than indicated.
As I pointed out in my letter, every thing else remaining equal, the 10-yr PE ratio is likely to decline a bit over the next year as low earnings from the 2001-03 period are excluded from the data. But Siegel obviously didn’t crunch the numbers because, in fact, the difference in valuation is small. I addressed this in my letter — the table on page 4 of our Market Update compares the 10-yr PE ratio of 21.5 with a 7-yr PE ratio at 20.8 (which removes the tech wreck earnings recession from the data).
What does this mean in plain english? The market is trading in the upper reaches of its “fair valuation” range, not quite in yellow light territory. But the market isn’t undervalued either. Read my Q4 letter for more.
In the end, it pays to remember that models such as Shiller’s PE-ten are only tools and we will never use them in a vacuum to determine your investment positioning. Judgement is always needed. Here is the NY Times Article in .pdf format Dueling Prisms for Market Valuation.