Back in August of 2014, I wrote a post titled Is it time to get out of the market? At that time, the Shiller Cyclically Adjusted Price Earnings Ratio, or Shiller P/E, a price earnings ratio based on the average inflation adjusted earnings from the previous ten years, stood at a level of 25.09 (vs. a long-term mean at that time of 16.54). Investors were feeling nervous, and headlines like It’s the worst possible time to buy stocks weren’t helping. Since August 2014 the S&P 500 Index is up 9.77% in USD, and a whopping 27.33% in CAD; getting out of the market, or waiting for a lower Shiller P/E before investing, would have resulted in significant missed opportunities.

At the time of writing this post the Shiller P/E stands at 26.33, and investors are again feeling nervous about an overvalued market headed for a major correction. Larry Swedroe recently wrote about why the Shiller P/E is may not be a valid method for comparing past and current market valuations – I have summarized his points.

• The U.S. market has improved regulation, a more experienced Federal Reserve, and greater overall wealth. It makes logical sense that the cost of capital in a more developed financial market is lower (meaning the Shiller P/E is higher) than it was when that same market was less developed. A Shiller P/E higher than the historical average should not come as a surprise.

• The Financial Accounting Standards Board changed the rules around writing off goodwill in 2001 resulting in the current valuations of stocks appearing to be more expensive relative to the past than they actually are. Swedroe writes that adjusting for this accounting change would lower the current Shiller P/E by about 4 points.

• For fair comparison of past and present Shiller P/E ratios, they must be normalized for differences in dividend payout ratios. Dividend payout ratios today are significantly lower than payout ratios in the past. Adjusting for this differences explains about 1 point of difference between the historical and current Shiller P/E.

• Cash on balance sheets increases P/E ratios, debt decreases P/E ratios, and relative to history, U.S. companies are holding more cash and less debt than they have in the past. This pushes up the Shiller P/E.

• The liquidity premium for holding stocks has decreased as bid-offer spreads narrow due to things like the decimalization of stock prices and the additional liquidity provided by high-frequency traders. Index funds and ETFs have also given investors the ability to indirectly hold illiquid stocks, reducing the sensitivity of their returns to liquidity.

Adjusting for these factors, Swedroe estimates that a Shiller P/E very close to the current level of 26.33 should be expected. When the current historical mean of the measure (going back to the late 1800s) is 16.61, it is very easy to get nervous about a mean-reverting market correction, but when this mean is adjusted for current market conditions, the U.S. market no longer appears to be overvalued. It is important to note that based on this analysis, and barring a market correction, the expected returns of U.S. stocks are expected to be lower going forward than they have been in the past.

While the Shiller P/E provides some interesting data for discussion, allowing it to influence investment decisions is unlikely to result in a  positive investment experience. Ignoring the noise and staying invested is an approach much more likely to result in both investing success and peace of mind.

Original post at pwlcapital.com