Posted on April 14, 2010 by Ben Connard 

The market has increased about 50% over the last year, causing many talking heads to wonder if the market is over-valued. One simple method of valuation is the current P/E ratio. Is today’s P/E ratio higher or lower than the historical average?

Behavioral economist Robert Shiller, perhaps best known for his March 2000 book Irrational Exuberance which correctly predicted the tech bubble, publishes historical P/E ratios. These numbers can provide general insight as to whether the market may be over or under-valued. He tabulates a Cyclically Adjusted Price to Earnings (CAPE) Ratio using an inflation adjusted S&P 500 Index and inflation adjusted earnings. He takes the average of the trailing 10 years of earnings to smooth out cyclicality.

According to Shiller’s numbers as of the end of March, the market was trading at a CAPE Ratio of 21.3. The historical average is 16.4; however, this ratio includes figures dating back to 1881. At the turn of the 20th century, the stock market was 63% railroads. I don’t believe this is comparable to today’s marketplace. If we calculate the ratio since 1960 (since the ratio includes 10 years of trailing data, this includes only post-World War II), the ratio jumps to 19.4, still lower than today but not suggesting a gross over-valuation. If we look at post 1985, the ratio jumps to 23.6. In some ways, this is the most comparable time period, since 1985 stocks have paid lower dividends (below 4%). This increased their retained earnings, which in theory allows for faster growth and higher multiples.

The conclusion is that while the market is not over-valued today, it’s not undervalued as it was a year ago when the CAPE Ratio was 13.3. During this past year we purchased quite a few names to take advantage of the buying opportunity. There are less buying opportunities today, but we don’t see a wildly over-valued market.