Whither Equities?

by George Hatjoullis


The Shiller PE Ratio seems rather high at the moment. This ratio measures the average inflation adjusted earnings from the previous ten years and places it in relation to current price. It is the current stock price divided by this measure of earnings. Stock prices are rather high in relation to the last ten years of earnings. Does this mean a stock market crash is imminent? Clearly no, as there is no way of telling how ‘overvalued’ stocks can get or for how long. There is however cause for concern.

The PE ratio is a cousin of the payback rule in finance. It measures how many years it will take to get back your investment if the current annual earning estimate is projected forward. The longer it takes to get your money back the riskier is the investment. This is a very crude valuation tool that takes no account of the time value of money. A pound tomorrow is worth less than a pound today because you can earn interest on a pound today (I cannot simplify Present Value more than this). The payback rule and the discounted present value rule, which adjusts for time value, give the same result only if interest rates are zero. Guess what, interest rates are very low.


As the above chart illustrates, ten-year bond yields are unusually low. What this means is that the historical Shiller PE ratio is comparing apples and oranges. For any given projection of earnings, the present value of these earnings depends on the discount factor that you use. The higher the discount factor the lower the present value. The discount factor is correlated with bond yields. So the degree of over or undervaluation of stocks as signalled by the Shiller PE ratio will vary with interest rates. If you compare the two charts it is just about possible to make out that in the 1950s interest rates were on a par with those seen today. The Shiller PE ratio was around 10 and a substantial bull market ensued. It ended in the mid 1960s (at a Shiller PE of around 25) as interest rates started to rise. It never really got going again until the mid 1980s when interest rates began the secular decline which may well have ended in 2016. The important point is that the decline in interest rates may well have ended.

In the 1930s, 2001, and 2007, interest rates were higher than they are today, so the degree of overvaluation of earnings was greater. The comparable period is the 1950 decade when interest rates were similar to today’s levels. If interest rates are about to rise, even slowly, then a Shiller PE ratio of almost 28 is looking rich. The ratio needs to come lower. Either earnings must rise faster than stock prices or stock prices must fall. Of course, if interest rates do not rise or fall further the Shiller PE ratio could hang around here or even go a bit higher even if earnings match expectations.

The conclusion is what we already know. Interest rates, and by implication inflation expectations, are key to the next big move in stocks. The Shiller PE ratio contains some information but it is incomplete. Blogs that quote this as a reason to be immediately bearish are misleading. Just watch the Fed and do not sell a market making new highs. Wait until a downtrend is formed. You may not get the top but the more certain you are of a downtrend the easier the ride.