We have never been great fans of the “Shiller P/E” based on 10-year moving averages.  Much, much better than spot P/E but still too short-term to cope with the sometimes outsize cyclical fluctuations in earnings.

But we are great fans of the Shiller data, and one valuation check we use is to look at the multiple of very long term trend earnings. That seems to us to address a really fundamental question; how much  are investors prepared to pay for a year’s worth of trend earnings?

More when (real) bond yields are low, less when they are high would be one part of the answer (i.e. when the real discount rate is low a long lives stream of cash flows is very valuable). More when peace and prosperity have reigned for a while, and earnings growth is (abnormally) stable, less in times of war, high inflation, or when the banking system is effectively bust.

The trick is to figure out what long-term trend earnings are, and whether the trend might conceivably shift or change slope.

That’s where the Shiller data comes in: we deflate by the CPI to get real earnings and then put it into logs to get the following chart.

It looks like the long term trend in real earnings growth is about 2% per year, very much in line with GDP per capita. That seem sensible. The tricky bit is that within the full Shiller data set there was actually  a downshift, not in the slope but in the level of real earnings during the post WWI deflation/slump.

It might be happening again for all we know, but lets assume for a moment that the old trend is intact. Then you can do a chart of trend P/E by converting the real series back into nominal dollars (current number about $61).  Our bottom line is that we think 13 to 20 times trend earnings make sense for now, especially when you look at our measures of the real discount rate.  See charts below.

But there are other possible interpretations.

Any offers?

Jonathan Wilmot, chief global strategist at Credit Suisse Investment Bank, is blogging at FT Alphaville for the day.

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This entry was posted by Jonathan Wilmot on Tuesday, December 1st, 2009 at 17:40 and is filed under Capital markets, People. Tagged with Price earnings ratio, robert shiller. Edit this entry.