12.09.2016

DOW @ Record Highs: Why Shouldn’t One Fall In Value Trap?

With the US equities firmly setting themselves up around all time highs, the doomsday predictions have started flowing in. This is typical scare mongering which has been witnessed every time a prominent trend stays in place for a sustainable period of time. Equities have been remarkably resilient this year, factoring in fallout from events like Brexit and the Trump victory. However, “While the S&P 500 is reaching all-time highs on optimism over Donald Trump's economic agenda, some Wall Street strategists are increasingly worried about a widely followed valuation measure that's reached levels that preceded most of the major market crashes of the last 100 years” ,  (http://www.cnbc.com/2016/12/08/market-indicator-hits-levels-last-seen-before-plunges.html )

To be sure, the valuations have been elevated. But is that a good enough reason for the bulls to start offloading their prized possessions? The article says that the Shiller "cyclically adjusted price-to-earnings ratio" (CAPE) is calculated using price divided by the index's average historical 10-year earnings, adjusted for inflation. Yale economics professor Robert Shiller's research found future 10-year stock market returns were negatively correlated to high CAPE ratio readings on a relative basis. He won the Nobel Prize in economics in 2013 for his work on stock market inefficiency and valuations.

Here is the chart being refereed to…

Shiller CAPE PE Ratio 
 http://fm.cnbc.com/applications/cnbc.com/resources/editorialfiles/charts/2016/12/1481213614_schiller-indicator.PNG

 While the article is right in pointing out that the current levels have been exceeded only thrice in last one century, the difference in absolute values on the chart over last one decade is puzzling. The CAPE strode up to near 45 levels at the height of the 2008 debt fueled rally. The metric currently stands at just about 28 now. One more important point to consider is the alarming spurt in global central bank assets. Major central banks have witnessed a tremendous spike in their balance sheets in the aftermath of the global financial crisis. The aggregate size of major central assets is up from $5.5 Trillion to $18 Trillion over last eight years.
  
Coming back to the CAPE, it is important to note that the value of the metric has been elevated over last two to three years. In fact, in September 2014, when US stocks were rising in a similar manner and looking unusually expensive, Rober Shiller himself stated that 'We saw this before the Wall St crash, the dot-com bubble and the credit crunch". Will the CAPE hold true this time or investors would fall in a value trap? ...only time will tell! Read more: http://www.thisismoney.co.uk/money/investing/article-2742297/PROF-ROBERT-SHILLER-INTERVIEW-How-stocks-crash-2014.html#ixzz4SLTBjsva.
  


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