Investing with the Trend: A Rules-based Approach to Money Management

Chapter 8Market Facts: Valuations, Returns, and Distributions

Market Valuations

Because secular markets are defined by long-term swings in valuations, let’s look at the Price Earnings (PE) ratio and study its history. Robert Shiller created a valuable measure of PE valuation that uses trailing (actual) earnings, averaged over a 10-year period. (A87) (A89) Here is how it is calculated:

1. Use the yearly earning of the S&P 500 for each of the past 10 years.
2. Adjust these earnings for inflation, using the CPI (i.e., quote each earnings figure in current dollars).
3. Average these values (i.e., add them up and divide by 10), giving us e10.
4. Then take the current Price of the S&P 500 and divide by e10.

Figure 8.1 shows the S&P Composite on a monthly basis adjusted for inflation, back to 1871, with a regression line so you can get a feel (visually) of where the current price is relative to the long-term trend of prices. The lower plot is the Shiller PE10 plot with peaks and troughs identified with their values. You can see that all prior secular bears ended with PE10 as a single digit (4.8, 5.6, 9.1, and 6.6). The PE10 on March 9, 2009, only got down to 13.3, which is considerably higher than the level reached by all prior secular bear lows. Based on this simple analogy, I think we have yet to see the secular bear low for this cycle. Remember, it does not mean that the prices have to go lower than they did in 2009; it just means the PE10 should drop to single digits. Remember, PE is a ...