I recently came upon this article where Evan Simonoff reports on Wharton School of Finance Professor Jeremy Siegel’s analysis of equity market valuations. The esteemed professor spoke at the ninth annual Inside ETFs conference and focused on Robert Shiller’s cyclically adjusted price-to-earnings (CAPE) ratio, for which the Yale University economics professor won a Nobel economics prize.
At the outset, Jeremy Siegel suggested that Shiller’s metric contains major flaws. After all, as the article notes, “it flashed sell signal in May 2009, perhaps the best time to buy stocks since the early 1980s.” The article goes on to note that between 1981 and 2015, the CAPE ratio signaled that equities were overvalued in no fewer than 416 of 422 months.” Clearly, this would not be the view of Siegel, a perennial market bull!
The article stresses that Siegel believes the key flaws in the Shiller P/E are not Shiller’s fault. As Simonoff summarizes, “in 1990, Standard & Poor’s, following the Financial Accounting Standards Board, changed the definition of GAAP (generally accepted accounting principles) earnings to require mark-to-market accounting. But the change in criteria only required that companies mark down their assets when they have a loss. When an asset increased in value, it could only be marked up when it was sold.”
Reporting on how Siegel showed the predictive powers and limitations of the Shiller P/E surfaced in the last decade, Simonoff writes, “In 1999 and 2000, the prices of certain stocks reached absurd levels, and Shiller’s proved an excellent indicator. Then in the 2008-2009 period, corporate earnings collapsed and P/E ratios soared. The events, almost polar opposites, occurred twice in the same decade. That largely explains why the Shiller P/E indicated equities were overvalued in May 2009.”
As for current equity market conditions, Simonoff reports that “Siegel went out of his way to dismiss the popular perception that the Federal Reserve’s easy monetary policy is artificially inflating stocks.” But that does not mean Siegel expects equities to soar. In fact, Simonoff writes that diminished expectations likely will result from “slightly high valuations, slow economic growth and the risk aversion associated with an aging population.”
However, true to his bull status, Siegel noted that given that bond market investors can expect just 1.0 or 1.5 percent after inflation, equities still look attractive. In fact, he expects 4 to 5 percent growth, not the 2 percent now forecasted by the Congressional Budget Office.