The most popular measure of the stock market's value 'deserves to be trashed'

pulse

July 12, 2017 3:21 PM

The Shiller PE ratio adjusts for inflation — but that's not enough.

Many ways to measure the stock market's value are trading at or above their historical average.

cyclically-adjusted price-earnings (CAPE) ratio because it takes the price of the S&P 500 and divides it by the average of ten years worth of earnings. By averaging, the ratio accounts for the noise that different business cycles and other temporary events introduce.

When the PE ratio is above its historical average — like it is now — the market is considered expensive.

"It's a flawed metric," said David Bianco, the chief investment strategist for the Americas at Deutsche Asset Management, at a media briefing on Tuesday. "W

He added that as economists question the usefulness of principles like the Taylor Rule and the Phillips Curve, investors, too, should rethink the Shiller PE.

Bianco has a longstanding disagreement with the CAPE ratio. He reiterated it in the context of forecasts that stock market returns would be lower for the rest of this cycle given the market's stretched valuation.

Whats wrong with Shiller PE?

The CAPE ratio accounts for inflation in its earnings adjustment. However, earnings should always rise more than the inflation rate because companies don't pay out 100% of their earnings, Bianco said.

The share of profits that companies don't pay out as dividends and keep to reinvests or debt payments — retained earnings — aren't accounted for in the Shiller PE, according to Bianco.

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