Executive Summary
? The current 10-year Shiller P/E Ratio (or CAPE) includes two of the worst earnings declines in history.
? The current period is the only time when ten years captures two earnings declines that exceeded 40%.
? Investors may be overly bearish by only focusing on the 10 year P/E and projecting the past decade's declines far into the future.
? At this time, we recommend that investors focus more on current valuation measures.

Valuation Measures
Investment professionals often commit significant resources identifying and leveraging different market metrics to help explain and anticipate stock returns. Some valuation-based stock market measures have proven useful in identifying potential opportunities and risks. Valuations compare stock prices to the fundamentals (i.e. growth, revenues, earnings, management and capital structure) of the underlying companies. High valuations may indicate a bad time to invest because stocks are expensive relative to their fundamentals. Low valuations may indicate a good time to invest because stocks are cheap relative to fundamentals.

Shiller Cape Ratio
One popular valuation metric, the Cyclically Adjusted Price-Earnings (CAPE) Ratio, was developed by Robert Shiller. Robert Shiller aims to make earnings more useful as a measure of value by looking at a full market cycle, which he defines as ten years. He takes ten years of earnings, adjusts them for inflation, and divides into the current market price. A full ten-year period is likely to include times when companies are overstating earnings to meet expectations, as well as times when they are taking big write-offs. The view is that averaging all those environments together may result in a metric that is less susceptible to distortion.

The Shiller CAPE Ratio has been useful in identifying when stocks have been over-priced. For example, at the peak of the technology bubble in March 2000, the Ratio reached 44.2, an all-time high, correctly signaling that stocks were extremely expensive at that point. In 2007, the Ratio peaked at over 27, which is high relative to the long-term average of 16. This was just before the financial crisis of 2008-2009, which resulted in sharply negative returns for stock investors. But, will this measure continue to be useful in identifying the next crisis? More importantly, what does it say about stock prices now?

As of July 31, 2011, the CAPE Ratio was about 22, a relatively high figure. There is a good reason to question the reliability of this metric today. What weakens the value of the CAPE Ratio is precisely what makes it tick - the averaging of ten years of earnings. While this has typically been effective in smoothing out the typical earnings reporting cycle, the past ten years have been exceptional. Two of the biggest declines in stock earnings occurred over this period, substantially deflating the fundamentals that the ratio seeks to measure, potentially making stocks appear more expensive than they actually are.



Earnings Declines In Recessions

We studied the declines in company earnings during each recessionary period since 1873* and measured the change in earnings from the start of the recession to the end of the recession. Earnings declined by an average of about 16% in a typical recession, a fairly significant amount. Moreover, two of the greatest historical earnings declines occurred in the past ten years. The first occurred during 2001 when earnings fell over 43% in response to the bursting of the tech-stock bubble. The second occurred during the 2007-2009 crisis, when earnings plummeted over 88%.

A total of 29 recessions have occurred since 1870, so a ten-year period that includes two or more economic shocks is not uncommon. Nonetheless, the current period is the only time when ten years captures two earnings declines that exceeded 40%, which is a very significant point. Did the earnings at the nadir of those cycles accurately reflect companies' long-term power to generate profits? We think not. In particular, it may be possible that the write offs taken by financial companies in 2008 and 2009 as well as the significant negative earnings reported by telecommunications companies and tech-stocks in the aftermath of their bubble may be conspiring to distort the CAPE Ratio, even though that metric was designed precisely to avoid that sort of distortion.

So what should investors do in the face of a distorted valuation measure? While we feel that the CAPE Ratio is a useful measure of value, we feel it may be more appropriate to rely upon traditional valuation metrics at this time, because they are not affected by the crises of the past ten years. Traditional metrics like price to book value and price to sales indicate that large-cap stocks are trading at some of the cheapest levels observed since the early 1990s. Moreover, the traditional price-to-earnings ratio of the S&P 500 is approximately 13.0 as of mid-August 2011. With the exception of the market declines of 2008-2009, this is the cheapest level observed since the late 1980s, and one that provides an amount of cushion against a period of declining earnings.

We cited earlier that a typical recession is accompanied by an earnings decline of about 16%. At current stock prices, a decline in earnings of that amount would result in a P/E ratio of about 15.5 - in line with historical averages for that metric. Although we certainly cannot reliably predict what will happen to earnings in the future, much less the direction of stock prices, we feel that the balance of the data suggests that stocks represent a good value.

Summary
We believe that Robert Shiller produced a useful measure when he formalized the CAPE Ratio. However, in seeking to remove reporting distortions by using an inflation-adjusted ten-year average of earnings, it may be creating a distortion itself by including two of the deepest ever earnings declines in a single ten-year period. Investors may be better served by more traditional metrics such as price to book value, price to sales, and a traditional price to earnings ratio today, all of which indicate that large cap stocks are a good value. Although no valuation metric can tell you where a market will bottom or peak, we feel that there is a strong case to be made for owning stocks today based on these measures.

Andy Kapyrin, CFA, is director of research and Chris Cordaro, CFA, CFP, is chief investment officer at RegentAtlantic located in Morristown, N.J.