If you follow the markets at all you can’t avoid discussions of how overvalued the broad market as a whole may be. I largely ignore the talking heads for two reasons. The first there is always gong to be talk about a pull back (here are main stream articles from 2014, 2015 and 2016) and when the correction does happen there will be articles discussing how the market is going to rebound as well as fall more. This leads me to the second reason I largely ignore it – for my 401(k) it just doesn’t matter since I am 30 years or so from using the asset bucket…and despite recessions, depressions and war there are hardly any negative 10 year rolling periods since 1950.
Notwithstanding, everything I just said I just changed the allocation of my 401(k) for future contributions to 50% cash. I was finally inspired to make the change from another blogger and not the litany of financial publications I check out weekly (both main stream and trade publications). To understand the how and why there are a few definitions that are necessary
What is the Shiller P/E? What is CAPE Ratio? What is PE10?
The PE10, CAPE (cycilacly adjusted price to earnings) Ratio, and Shiller P/E are the same thing are often used interchangeably when reading on the topic. Price to earnings ratio is the ratio of a company’s earnings when compared to the stock price at a given moment. It is probably the most used valuation starting point.
According to investopedia,
The P/E 10 ratio is based on the work of renowned investors Benjamin Graham and David Dodd in their legendary 1934 investment tome “Security Analysis.” Graham and Dodd recommended using a multi-year average of earnings per share (EPS) – such as 5, 7 or 10 years – when computing P/E ratios to control for cyclical effects.
The P/E 10 ratio is calculated as follows – take the annual EPS of an equity index such as the S&P 500 for the past 10 years. Adjust these earnings for inflation using the CPI. Take the average of these real EPS figures over the 10-year period. Divide the current level of the S&P 500 by the 10-year average EPS number to get the P/E 10 ratio or CAPE ratio.
The P/E 10 ratio varies a great deal over time. According to data first presented in Shiller’s bestseller “Irrational Exuberance” (which was released in March 2000, coinciding with the top of the dot-com boom), updated to cover the period 1881 to November 2013, the ratio has varied from a low of 4.78 in December 1920 to a peak of 44.20 in December 1999.
It takes the price to earnings (which compares the price of a stock or index to its earnings) ratio, which is probably the most common way to value an equity/index to a whole other level. A stock’s price (i.e. quoted price when you go to google finance), in it of itself, does not indicate its value since the amount of shares and how much each share earns is not taken into account. That’s where the PE Ratio comes it since it provides a baseline to compare one stock to another without worrying about how many shares are outstanding.
The Shiller PE or CAPE or PE10 tries to ‘normalize’ the earnings part of the equation by taking into account an average of the earnings rather than one quarter.
Where is the CAPE at Today?
I knew the broad market was ridiculously hot recently, but it wasn’t until I read a fellow blogger’s post about how ridiculous it really was that I decided to take some action. LazyManandMoney recently wrote a post titled, Why (and when) You SHOULD Time the Market, which really provided some astounding CAPE statistics:
Here’s what I see. From 1880 until 1995… a span of 115 years, nearly any time the Shiller P/E got above 20 the market would crash:
- It hovered in the 20’s around 1990… and worked its way down to 5 in 1920.
- Then over the next 10 years people got really excited and it worked its way to 30 at the top of 1929 stock market crash… and then it crashed back down to 5 by ~1932
- Then ~1936 it got up around 22… and then it crashed down 9 by ~1942.
- From ~1955 to ~1965 it hovered around the 20 range peaking at around 24… and then it crashed to around 7 in ~1982
- From that 1982 to 1987 it moved up from 7 to 17 and then had a mini-drop to 14 on Black Monday.
From the above, it feels to me like 20 is DEFCON 3, 25 is DEFCON 2, and 30 is DEFCON 1.
From 1995 to now, things get very interesting.
- From 1995 to 2000, Shiller P/E jumped from 20 to 44. That DotCom Boom was really something, wasn’t it?
- From 2000 to 2002, it went from 44 to ~23. That DotCom Bust was really something, wasn’t it?
- From 2002 to 2008, we a recovery up to around 27
- From 2008 to 2009, the P/E dropped from that 27 to 15. This period is commonly known as the Great Depression
- From 2009 to today, the P/E has mostly gone straight up from 15 to 30. For the majority of personal finance bloggers, they’ve only known this era of prosperity.
We’ve seen the Shiller P/E reach 30 three times. The first was the 1929 crash. The second was May of 1997 a couple of years before the peak and DotCom crash in Dec. 1999. From the graph these two crashes look to be the largest in American history… and it’s not even close.
So what does the Shiller P/E look like today? From Multpl.com:
Want to know what I find even odder? The market doesn’t seem to care that we are near a possible war, and a supposed nuclear one at that. Sure the S&P500 is down for the last 5 days but look at the year to date chart we are still up 9%! Just seems like to me a sign that literally no one cares because the stock market always goes up, right? It is as soon as everyone believes that it a major down turn happens.
What Did I do to my 401(k) in Response to the Shiller PE?
For the most part I like to ignore my 401(k) because who the hell cares what happens today when I can’t use it for 30 years, right? The above information has me semi-spooked, so I decided to take a controlled response to it all. I am not a “sell it all kind of guy.” For a couple reasons, but mainly because there is not a soul who can call the top or bottom of a market. Anyone that tells you they can do it, and is not running a hedge fund is literally just full of shit. They may believe in their own bullshit but it is bullshit nonetheless.
So since I am not willing to sell it all, I am going to do 2 things:
- Take 10% off the table, across the board, and put it into cash; and
- Put 50% of my future contributions into cash.
The risk is clear – the market keeps RIPPING upwards and I miss out on most of that growth (I still have some future contributions going to equities and I only took some off the table), however, the other side of the coin is pretty clear also that there is a pull back and I’ll have some cash to invest.
The problem with getting out of the market is knowing when to get back in, so I am going to give my self a point to start deploying cash…after a 5% correction (from this point – so the S&P would be at 2,318 or so). If it does not occur by year’s end I will reevaluate the strategy.
Have you taken any reaction to the markets?