The Dow Jones Industrial Average may be older and more widely cited, but the S&P 500 Index's market-cap weighting makes it closer to the ideal "market portfolio" envisioned in the efficient-market hypothesis.
An S&P 500 Index fund can serve as an effective building block for exposure to United States equities. The index contains 500 of the largest publicly listed U.S. companies. And for the most part, it has lived up to the expectations of the efficient-market hypothesis, proving to be extremely difficult for active managers to beat consistently after fees.
The market isn't cheap, but perhaps not as rich as CAPE crusaders suggest
Finishing the year at 1,848, the S&P 500 Index had a 32.39% total return in 2013. At this point, the market appears fully valued and more expensive than it has been for the past several years. Based on Morningstar equity analysts' fair value assessments of the index's underlying constituents, the S&P 500 is trading at a price/fair value multiple of 1.03, or slightly above fair value.
While the market no longer looks cheap, it is not necessarily expensive, either. Bears like to point out that the cyclically adjusted price/earnings (CAPE) ratio is at 25.5 times, well above its post-World War II average of about 18.4. The CAPE is a P/E ratio that uses trailing 10-year earnings to smooth out cyclicality. Thus, at a CAPE of 25.5, the market would appear overvalued. But there are several reasons why a historical comparison based on the P/E ratio alone may overstate the market's current valuation.
First of all, a P/E ratio measures the current market value of a company's equity to its earnings. If a company has excess cash on the balance sheet, that cash is implicitly included in the price you pay for the stock. But since it is excess cash, it is not used to generate earnings. Thus, the numerator of the P/E ratio gets inflated by cash while the denominator does not. Another way the effect of cash on stock prices can be seen is when companies pay dividends. The share price drops by the amount of the dividend.
Since the financial crisis, cash on the balance sheets of nonfinancial U.S. companies has reached record highs, doubling to about US$1.4 trillion, or US$158 per index unit. The record level of cash makes historical comparisons using the P/E ratio less meaningful. If we assume all of this growth in cash -- or half of the current amount, meaning US$79 per index unit -- is excess cash that is unnecessary to run the business and generate current earnings, then an adjusted level for the S&P 500 that removed this excess cash would be closer to 1,769, resulting in a CAPE of 24.5 rather than 25.5 without deducting the excess cash. Accounting for cash shaves almost a full point off the CAPE.
A second reason why a comparison of the current CAPE to its historical average is less meaningful: The level of interest rates has changed. Despite its simplicity, the P/E ratio has a solid theoretical underpinning in dividend-discount and free-cash-flow-discount models. These models suggest that stock prices reflect the sum of all future cash flows discounted at the appropriate rate of interest. Lower interest rates, in theory, should result in higher prices, and that is exactly what we find in the data. Since 1946, when the real 10-year Treasury rate has been between 1% and 4%, the average CAPE has been 20.87. Lower and even negative real rates, such as in the inflationary 1970s, corresponded to a lower CAPE. Periods of higher real interest rates, such as in the early and mid-1980s, also correspond to a lower CAPE. The current inflation rate of about 1.20% and the 10-year Treasury rate of around 3.00% translate into a real rate of about 1.80%, suggesting that it is not unreasonable for the CAPE to be above its long-term average.
Sources: Robert Shiller and author's calculations.
Sources: Robert Shiller and author's calculations.
