Practical analysis for investment professionals
29 March 2018

The Case for Further Stock Market Gains

The stock market’s valuation recently surpassed its 1929 peak, and the S&P 500 now trades near the second highest level on record as measured by Robert J. Shiller’s CAPE ratio. It is still below the valuations achieved during the dot-com bubble, but relative to history that era was an anomaly.


The S&P 500 CAPE Ratio

The S&P 500 CAPE Ratio

Source: Robert J. Shiller


However, Jeremy Siegel has shown that the CAPE ratio may overstate market valuation because of changes in the way S&P 500 earnings have been calculated, among other factors. Additionally, now that there is a new corporate tax regime, historical earnings-based measures of stock market valuations may be even less relevant for forward-looking purposes.

But after making two simple and fairly naive adjustments to earnings based on these issues, we believe there is a reasonable case for further stock market appreciation.

Our first adjustment picks up on Siegel’s point that S&P 500 earnings during the Great Recession were unfairly penalized by AIG. The AIG bust effectively wiped out the earnings of every other company in the index.

To say that the entire S&P 500 had zero earnings exaggerates reality. Siegel’s “The Shiller CAPE Ratio: A New Look” published in the CFA Institute Financial Analysts Journal presents this case in much more detail.

To adjust for this abnormality and recognizing that the impact will roll out of the current CAPE calculation in roughly 20 months, we recalculated the current CAPE ratio but started averaging earnings in November 2009 rather than March 2008.

We then used consensus S&P 500 earnings forecasts from Thomson Reuters I/B/E/S Estimates for the remainder of 2017, 2018, and 2019 to come up with 10 years of earnings.

“Anniversarying” the earnings from the Great Recession results in an adjusted CAPE ratio of 25.7, significantly below today’s raw reading of 33.

Our second adjustment to the earnings data reflected the new tax law. With the corporate tax rate now at 21%, down from 35%, earnings should theoretically be higher going forward.

Some accounts estimate that aggregate corporate earnings could rise by 10%. To reflect this, we adjusted historical earnings by 10% to come up with a pro forma of what they would have been if the tax law had been consistent over the past 10 years. This further reduces the adjusted CAPE ratio to 24.

There is certainly room for a more thoughtful and rigorous analysis of these adjustments, and there are many other factors that will influence the stock market going forward. But a case can be made that stocks are not as overvalued as headlines suggest.

In fact, if our adjustments are accurate, the stock market currently trades below its average CAPE ratio since 1990 of 25.6.

If today’s raw CAPE ratio is a level at which the market can trade and if we apply our earnings adjustments, the S&P 500 could, in fact, rise to 3,543, well above its current mark.

While an increase of that magnitude is certainly not consensus, it would be in line with and is, in fact, far more conservative than Jeremy Grantham’s “melt-up” thesis that predicts the market could rise 60% from where it is today.

The stock market often moves contrary to consensus forecasts. In the face of many stock market naysayers, there is a compelling argument for further gains.

If you liked this post, don’t forget to subscribe to the Enterprising Investor.


All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images/Rawpixel Ltd

About the Author(s)
Mark Armbruster, CFA

Mark Armbruster, CFA, is president of Armbruster Capital Management, Inc. (ACM), a boutique wealth management firm serving high-net-worth individual and institutional clients. ACM uses index funds, exchange-traded funds (ETFs), and other investment vehicles to build portfolios designed to reduce investment-related costs and taxes in order to maximize net returns. Previously, he worked in equity research on Wall Street, following the aerospace and defense industries at Smith Barney. Armbruster also worked in the equity strategy group for Salomon Smith Barney’s Chief Equity Strategist. He also started an investment advisory firm, where he served as chief investment officer. Armbruster has served on numerous nonprofit and for-profit corporate boards. He also consults on and provides expert testimony for investment-related legal disputes. Armbruster has been quoted on investment matters in several investment publications, including the Wall Street Journal and Investor’s Business Daily. He frequently gives talks on investment matters to professional investor groups. Armbruster has served as president of CFA Society Rochester. He holds a degree from the University of Rochester.

1 thought on “The Case for Further Stock Market Gains”

  1. julian says:

    To bolster this argument, there is also about 1/2 as many stock’s and 2x the money chasing those, so supply & demand will also affect the today FV vs history.

Leave a Reply

Your email address will not be published. Required fields are marked *