Salient to Investors:

The cyclically adjusted price-to-earnings ratio – CAPE – correctly signaled frothy markets in 1929, 1999 and 2008. CAPE looks at 10 years of averaged profits so is considered a more conservative gauge.

S&P 500 has a trailing P/E of around 15, which makes the market attractive based on historical levels, and a CAPE of nearly 22 versus the long-term average of around 16.

Professor Jeremy Siegel at Wharton said distortions make CAPE a less useful tool because it includes a 90 percent annual earnings decline in Q1 2009. Siegel says the market is attractive considering how low interest rates are, and expects multiples to rise : meaning domestic stocks could return 10 to 12 percent a year over the next several years, especially if the economy begins to pick up.

James Stack at InvesTech Research says the past 10-years includes two of the worst profit recessions in history. Stack says normalized earnings works in periods that are more normal, unlike the past decade. Stacks says the true valuation picture may have been distorted by corporations using the past decade’s recessions to cleanse their balance sheets.

Professor Robert Shiller at Yale said that the unusually volatile earnings of the past decade is all the more reason to use CAPE. Shiller says that based on more than 140 years of history, the market’s CAPE indicates expected annualized gains of just under 4 percent, accounting for inflation and versus historical average real annual returns of over 6 percent for blue-chip.

Robert Arnott at Research Affiliates agrees that the unusually volatile earnings of the past decade is all the more reason to prefer to use CAPE, saying the Russell 1000 index trades at a trailing P/E ratio of around 16 because of peak earnings. Arnott says the large monetary easing of the past decade has artificially boosted profits – corporate earnings are the largest share of GDP since 1929, and wages are the smallest share of GDP since 1937. Arnott says these trends are unlikely to continue forever, and profit margins will eventually come down as the economy improves and companies start hiring more aggressively. While CAPE of the S&P 500 is historically high, domestic stocks are a better buy than 10-year Treasury notes.

Read the full article at