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Don’t Get Caught Up in a Numbers Game

By Jacob Wolinsky   |   Thursday, 06 Jan 2011 09:47 AM

The year is starting off with analysts predicting high GDP numbers and stock prices will increase in the next 12 months.

One serious economist who is neither a perma-bull nor a perma-bear is sounding the alarm: Robert Shiller.

While many forecasters are predicting the S&P 500 this year will reach levels above 1,450 from the current level of 1,270, Shiller last week predicted that the market will be at 1,430 in 2020.

Investors must first understand some important concepts about stocks before explaining his rationale.

Stock prices are driven by two factors: earnings and how much investors are willing to pay for those earnings (called the price-earnings ratio, abbreviated as the P/E ratio).

If a stock is earning $10 a share and is an average company, the stock should trade around 15 times earnings, which would price the stock at $150.

Investors many times get caught up in the euphoria of certain stocks and place much higher multiples. Therefore, if this stock was a dot-com stock losing millions of dollars each year, it might be trading at $1,000, which would be 100 times earnings during the dot-com bubble.

Shiller measures the fair value of the market by taking the past 10 years of earnings and applying the historic multiple of 15. The reason Shiller uses 10 years of earnings as opposed to one year of earnings is to even out high earnings during bubbles, and decreasing earnings during recessions.

The Shiller 10-year P/E, as it is called, has been one of the best indicators of what stocks will return during the next 10 years. If the P/E is 10, stocks should grow by their historical average of 1.5 percent (real, not nominal) and earn several more percentage points a year as the P/E gets closer to 15. If stocks are trading above 20, returns should be far lower since the market usually returns to a P/E of 15, which is a loss of 25 percent right off the top.

Therefore, if altogether the stocks in the S&P 500 earned an average of $85 during the past 10 years, it would justify the current S&P 500 price of approximately 1,270.

However, the Shiller P/E is now at 23 since S&P 500 stocks have earned on average only $55 per share during the past 10 years.

Using Shiller’s numbers, the market would have to drop a whopping 35 percent just to place it at fair value. The only other possibility is for earnings to grow so rapidly that the average earnings for the past 10 years would be $85. This is very unlikely.

This doesn’t mean the market is going to crash overnight.

When President Bill Clinton left office, the Shiller P/E was 45, meaning the market was due for a 66 percent downturn. This didn’t happen but the market did drop approximately 50 percent by 2003 before the next bull market began.

The point investors must realize is: don’t get caught up in the media’s euphoria. Even completely ignoring the frightening debt problems we have, the stock market is already highly rich.

This is why Shiller thinks that the stock market will only return 13 percent during the next 10 years. While Shiller might be wrong, historic evidence is on his side.

Prudent investors should be extra cautious investing at these high multiples.

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The year is starting off with analysts predicting high GDP numbers and stock prices will increase in the next 12 months. One serious economist who is neither a perma-bull nor a perma-bear is sounding the alarm: Robert Shiller. While many forecasters are predicting the S P...
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