AQR’s Cliff Asness released in November last year a great piece called, “An Old Friend: The Stock Market’s Shiller P/E (.pdf)” dealing with some of the “current controversy” around the Shiller PE, most notably that the real earnings used in the Shiller PE are lower than they would otherwise be because of two serious earnings recessions: the tail end of the 2000-2002 recession, and the monster 2008 financial crisis.

The Shiller P/E represents what an investor pays for the last 10 years’ average real S&P 500 earnings. The ten-year average is believed to be a more stable measure than a P/E based on a single year of earnings, and therefore more predictive of long-term future stock returns and earnings. Asness notes that the selection of a ten-year average is arbitrary (“You would be hard-pressed to find a theoretical argument favoring it over, say, nine or 12 years”), but believes that it is “reasonable and intuitive.”

Asness asks, “[W]hy do some people dismiss today’s high Shiller P/E, saying it’s not a problem? Why do they forecast much higher long-term real stock returns than implied by the Shiller P/E?”:

They point out that we had two serious earnings recessions recently (though only the tail end of the 2000-2002 event makes it into today’s Shiller P/E), including one that was a doozy following the 2008 financial crisis. … So we have to ask ourselves, is the argument against using the Shiller P/E today right? Are the past 10 years of real earnings too low to be meaningful going forward (meaning the current Shiller P/E is biased too high)?

Asness shows the following chart of a rolling average of 10-year real S&P 500 earnings (a backwards looking 10-year average):

The chart demonstrates that 10-year real earnings used in the Shiller P/E are currently slightly above their long-term trend. At their low after the financial crisis, they fell back to approximately long-term trend. Asness comments:

It has not, in fact, been a bad prior decade for real earnings! The core argument of today’s Shiller P/E critics is just wrong. While the graph speaks for itself, there is some logic to go with the picture. Critics of the Shiller P/E point to the earnings destruction right after 2008 and ask how we can average in that period and think we have a meaningful number? After all, aren’t we averaging in a once-in-a-hundred-year event? But they usually do not object at all to the very high earnings, for several years, right before the bubble popped in 2008. One view of earnings is that the 2008 event stands alone. It didn’t have to happen, and doesn’t have relevance to the future and should be excluded from our calculations lest it bias us to be sour pusses. That is not my view (granted I’m a bit biased to sour puss in general). Another very different view is that the earnings destruction post 2008 was making up for some earnings that, for several years prior, were “too high”, essentially borrowed from the future. In this case, the post 2008 destruction is valid for inclusion as it’s simply correcting a past wrong. Rather than invalidate the Shiller method, the 2008 earnings destruction following the prior earnings boom is precisely why the CAPE was created! Not surprisingly I fall into this latter camp. I think the above graph is a TKO. Those who say the Shiller P/E is currently “broken” have been knocked out.

So, according to Cliff Asness, despite the recessions in 2000-2002 and 2008, the real ten-year average of earnings used in the Shiller PE is slightly above its long-term trend. Note that the current Shiller PE multiple of 23.5 is also about 42 percent above its long-term average of 16.5. Together, these two observations make the market look very expensive indeed.

Read An Old Friend: The Stock Market’s Shiller P/E (.pdf).

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