Shares RouteMap: Cyclically-Adjusted Real P/E Ratio

Buy when the yellow line is low, sell when it is high


sample chart of cyclically-adjusted real PE. Premium / Discount to Fair Value is yellow.

This strategy shows how cheap or dear are shares in real terms after allowing for inflation. It shows the difference between actual and Fair Value PE ratios after both EPS and the rate of inflation have been cyclically-adjusted by smoothing out over a typical economic cycle. The underlying valuation series is also shown in Momentum & Value charts.
 
The stock market index is shown in as the thick white line on the right hand axis. The two explanatory variables, Neutral valuation based on inflation, the straight orange line, and premium or discount to Fair Value, the yellow line, use the left hand axis. For comparability, stock market indices have been rebased to set year-end 1994 at 100.

Please note that this allows for traditional differences in valuation between countries because Neutral is set at the average valuation for the period over which meaningful data is available.

It differs from the well-know Graham and Dod PE Ratio in three respects. Firstly it normalised EPS not over ten years, but over a typical four year economic cycle. Secondly that reduces the need to deflate both EPS and Index by inflation to remove money illusion. Thirdly it subtracts the rate of inflation, similarly normalised.

Please note that a similar type of chart for styles and sectors and regions does not include this additional third modification for inflation. This sophistication is not necessary because comparisons are normally within the same country or region. See Styles & Sectors > Cyclically-Adjusted PE

These modifications generate much more useful valuation ratios in that they swing through a narrowed range and do so more frequently, than the once in one or two decade extremes of the Graham & Dod PE ratio.
 
In general the more financially sophisticated the country, the more closely the actual Cyclically-Adjusted PE Ratio has reflected Fair Value, as predicted by our models based on changing rates of inflation. Thus it has been most useful for developed Anglo-Saxon markets and least useful for low income emerging markets that may have experienced hyperinflation in the recent past.