Stocks have finally dropped below fair value...for the first time in 17 years.As we've often noted, Shiller's valuation method--cyclically adjusted price-earnings (CAPE)--is one of only two long-term stock valuation measures that have meaningful predictive ability (the other is a measure of replacement value called "Tobin's Q"). CAPE averages 10 years of trailing earnings and thereby mutes the impact of the business cycle, which otherwise distorts price-earnings ratios.
For the past 17 years, according to Professor Shiller, stocks have remained persistently overvalued, sometimes violently so. In the past two months, however, they have finally fallen below their long-term average.
Specifically, the average cyclically-adjusted PE for the past 130 years has been 16X. At the end of December, the S&P 500 was trading at 15X.
So does that mean stocks are going to go straight up from here? Absolutely not. As the last 17 years have shown, the gravitational pull around fair value over the short-term is weak. After past market peaks of this magnitude, prices have usually spent decades below fair value, and we expect we'll likely see the same pattern here.
As the accompanying chart shows, however, over the long haul, the reversion around the mean is powerful. And it suggests that, over the next couple of decades, the S&P 500 will deliver an average long-term return (6%-7% real).
See also: http://clusterstock.alleyinsider.com/2008/11/likely-s-p-500-bottom-600-down-40-from-here
