As we've often noted, Shiller's valuation method--cyclically adjusted price-earnings (CAPE)--is one of only two long-term stock valuation measures that have meaningful predictive ability (the other is a measure of replacement value called "Tobin's Q"). CAPE averages 10 years of trailing earnings and thereby mutes the impact of the business cycle, which otherwise distorts price-earnings ratios.
For the past 17 years, according to Professor Shiller, stocks have remained persistently overvalued, sometimes violently so. In the past two months, however, they have finally fallen below their long-term average.
This is the PE of the stock market with a 10-year moving average of earnings in the denominator. For the first time in 17 years, it appears that stocks are undervalued. Accordingly, the long-term expected real return from equities is 6%-7%.
With stocks in a free-fall, it appears that the market is on its way towards a single-digit PE.
Can the market trade at a 10-year moving average single-digit PE again? Of course it can. Markets can do anything.
However, it is worth noting that the three times when stocks became egregiously undervalued were
- During the Depression, the most traumatic economic event of the century
- During World War II, the most destructive war of the century
- When interest rates rose to the highest level of the century
So, if form is anything to go by, to fall to a 10-year moving average PE of less than 10x, this current economic event will have to be or lead to the biggest "something" of the century.