The Shiller PE Ratio Is Correct

 | Apr 24, 2014 | 5:00 PM EDT
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I have spent a fair amount of time this week reviewing the information about the Schiller PE ratios. I am pretty much convinced that Schiller has it right. Using the 10-year average of earning adjusted for inflation is an excellent measure of under and over valuation in broader markets and individual securities.

Rob Arnott, founder and chairman of Research Affiliates and Cliff Asness of AQR Capital have come to the same conclusion that I have, so I am comfortable with my assessment. The proof is in the results and from a long-term perspective, it works very well to help spot opportunity and danger.

I will also note that it is of very little value to short-term investors. It is not precise and using it to take leveraged trades betting on market directions would probably lead to severe financial distress in a pretty short period of time. Markets can stay undervalued or overvalued for extend periods of time. As Asness pointed out in a recent Forbes article, the current reading of 25 is in the 85th percentile – clearly, the market is expensive. However, the all-time Schiller P/E for the market is 45, so we could still see plenty of upside pressure. It is more of a flashing yellow light that indicates when to be aggressively looking for cheap stocks and when to be more cautious and start to sell any overvalued securities in your portfolio.

It was hard to turn around today without hearing how the current Schiller ratio is very high historically. When we apply it to sectors of the market, it becomes clear that, using this measure, only energy stocks can be considered cheap. Technology, healthcare and real estate stocks are at or near all-time Schiller readings. While we can still find some smaller companies in tech and real estate, the larger, better-known names -- and certainly the broad-based ETFs for these sectors -- are probably best avoided by most investors. I cannot find any bargains in healthcare based on assets so I am just avoiding the sector entirely.

I sat down this morning and ran a screen looking for those blue-chip stocks that have Schiller P/E ratios higher than the market and should probably be avoided by long-term, value-oriented investors. I am not a fan of blue-chips because I believe the long-term return potential from these prices does not make sense for most investors.

With the market at a Schiller P/E of 26, I looked for companies that have multiples higher than that level. One of the largest companies on the list is Disney (DIS). Let me be clear that I think Disney is one of the greatest companies on the planet. I am an annual Disney World pass holder and probably do the wine-and-dine stroll in Epcot once a month on average. If you look far enough back in the archives, you will find that I was banging on the table for the stock when it traded in the high teens and any reasonable estimate of the value of the company was in the low $40s. The current Schiller P/E is 30 and the stock trades at about 2x any reasonable estimate of corporate valuation.

I am not a huge fan of Starbucks (SBUX), but my wife and oldest daughter love the place, so I am no stronger to their products. It is a great company and I think they have one of the best CEOs in the world in Howard Schultz. However, you can pay too high a price for anything and the stock is clearly highly priced. Its Schiller P/E ratio is 67 right now. I cannot imagine that the company can grow fast enough to justify this multiple going forward and would avoid any new commitments to the stock for now.

When the market is priced on the high side of fair, it makes sense for investors to avoid stocks that are even richer in valuation that the broader market. If we do see a reversal, these stocks will likely lead the way lower and expose investors to the possibility of a permanent impairment of capital.

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