I first read about Cyclically adjusted Price to Earnings Ratio in Greg Mankiw’s post last week (referencing a WSJ article) and thought it was interesting but this week’s Economist article on the matter made me want to post it. Here’s the explanation from the Economist:
In his book, “Irrational Exuberance”, Robert Shiller calculated the cyclically adjusted price/earnings ratio over history. This measure, which takes an average of profits over the previous ten years and adjusts for inflation, is superior to the traditional p/e ratio because profits are highly volatile. In January 2000 the cyclically adjusted p/e on the S&P 500 was 44.3; the previous peak, just before the crash of 1929, was 32.6. That suggested markets had a long way to fall. And share prices did indeed suffer a long period of decline.
And here the gist of why this is a reason for long term optimism from Mankiw:
[T]he Standard & Poor’s 500-stock index is priced at 15 times earnings by the Graham-Shiller measure. That is a 25% decline since Sept. 30 alone. The Graham P/E has not been this low since January 1989; the long-term average in Prof. Shiller’s database, which goes back to 1881, is 16.3 times earnings. But when the stock market moves away from historical norms, it tends to overshoot.
And a reason as to why investors should be careful about acting on this advice without careful consideration (from the Economist again):
Why does this matter? The existence of a bear market does not preclude the possibility of fantastic returns over shorter periods. Indeed, one striking point about the Dow’s 936-point gain on October 13th was that it climbed more in that one day than it did in the first 85 years of its existence (it was founded in 1896). Two of the very best years in American stockmarket history were 1933 and 1935, right in the middle of the Depression. But bear markets behave rather like Lucy in the Peanuts cartoon strip. Just when Charlie Brown is persuaded to attempt to kick the football, she snatches it away. Just when investors are persuaded the bottom of a bear market has been reached, share prices slump once more.