Saturday, January 22, 2011

Irrational Exuberance: Chapter 1

In the year 2000, while many market pundits expected the market to rise continuously upward, Robert Shiller warned about the stock market bubble, though not that many paid attention. While most were blinded by optimism, Shiller demonstrated using fundamental analysis that the market would generate poor returns for years to come. Learning from and understanding Shiller's rational approach to market valuation is likely to aid the investor in avoiding falling prey to the bubbles of the present and future.

Shiller begins by putting the stock market level, as it stood in the year 2000, in historical perspective. While the Dow Jones Industrial Average (the Dow) had more than tripled since 1994, GDP and personal income was only up 30%. Corporate profits were up less than 60% over the same period.

A chart is shown illustrating the level of two variables: the stock market level and the market's earnings. Earnings had continued on their steady path, but the market level had taken off on a vertical spike at the time of writing. Shiller illustrates that the ratio of stock prices to earnings (a 10-year average of earnings in order to smooth out volatility, as discussed here) is at an absurd level. The PE 10 ratio is at 44 at the time of writing; the closest parallel is the 33 PE 10 ratio the market hit in September of 1929, just before it crashed.

Shiller then explores the question of whether there is any relevance to the market's P/E. To do this, he plots the market's PE 10 for all years since 1890 against its subsequent 10-year real returns. The resulting graph demonstrates that there is a relationship between a market's PE 10 and its subsequent returns. Based on the graph, negative returns over the next 10 years could have been expected from the year 2000. (As it turns out, returns over the next 10 years were indeed negative.)

3 comments:

Paul said...

Saj,

It seems like you may have posted about this at one time or another, but do you ever look at Buffett's Total Market Cap/GNP?

Jeff said...

The concept of averaging a stocks prior 5-10 year earnings to determine its earnings power make a lot of sense to me - but do you think it is relevant for high growth companies as well? When I look at a company like Ctrip, revenues have been growing at 25-30% a year for the last 10 years. It currently trades at a high trailing PE ratio - around 45. But how would one use the Schiller index for a company of this nature?

Saj Karsan said...

Hi Paul,

I do not, but I probably should. Do you know where this data is available on a near-realtime basis?

Hi Jeff,

I don't think this model applies well at all to growth stocks; I wouldn't bother using it for that.

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