Tags: Shiller | PE | interest | Japan

Japan Shows Shiller and Bears Could Be Wrong About P/E Ratios

By    |   Friday, 11 Apr 2014 07:55 AM

Stock market bears always seem to claim the market is overvalued and set to fall. They could be right, but their valuation models are usually incomplete. Price-earnings (P/E) ratios depend on interest rates, and low rates drive P/E ratios higher.

A common argument is that Robert Shiller's cyclically adjusted P/E ratio is higher than average. This has been true for almost all of the past 20 years, and an indicator that is consistently overvalued or undervalued for two decades does not provide useful information.

For U.S. stocks, the median Shiller P/E ratio has been about 16. The current level is 25. But with interest rates at record lows, the P/E ratio should be above average.

In Japan, the long-term median Shiller P/E ratio is 41, and the current level of 32 is undervalued despite the fact that it is twice as high as the long-term U.S. value. The ratio in Japan has not been under 20 since the market peaked in 1989.

If interest rates are low, as they have been in Japan for many years, stocks are worth more to investors. This is because many investors would prefer to have the chance of a 5 to 10 percent gain in stocks rather than accept the certainty of a 2 to 3 percent return from bonds. Their willingness to accept more risk for more gains increases the values of stocks. When rates are low, the "right" Shiller P/E ratio should be higher than average.

In the United States, we know the Federal Reserve intends to keep interest rates low for at least the next year and probably longer. That means stock prices could move much higher as investors abandon bonds in favor of stocks, and investors should ignore arguments about P/E ratios that do not adjust for interest rates.

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MichaelCarr
Stock market bears always seem to claim the market is overvalued and set to fall. They could be right, but their valuation models are usually incomplete. Price-earnings (P/E) ratios depend on interest rates, and low rates drive P/E ratios higher.
Shiller, PE, interest, Japan
299
2014-55-11
Friday, 11 Apr 2014 07:55 AM
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