According to the Shiller 10 year PE ratio the stock market is now trading at a hefty 18 PE. This is just slightly higher than the historical norm. Image 1 clearly shows that the market is neither extraordinarily expensive nor extraordinarily cheap, despite what some noted bears say. What is more interesting in this data is not the exact price, but the action surrounding overshoots and undershoots. In each of the instances where the S&P 500 approached an extreme overshoot of 25, the market undershot over the course of the following 5 years and always approached a PE between 5-10. Like Grantham, I am a firm believer in mean reversion and the idea that the mean tends to be overshot.
Chart 2 shows the extreme moves in terms of % above/below the long-term average. Although the market is not overly expensive or inexpensive it is interesting to note that we have not overshot to the downside despite the largest overshoot in the history of the market. This would lead one to believe that there is much more work to be done on the downside as PE’s contract and the market digests its excesses of the last decade.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.