The recent run in the major U.S stock indices has resulted in Schiller-PE charts being trotted out showing how far we are off the historical mean, implying a nasty pullback is in the works. The problem with a historical mean is that it is a single horizontal value on a chart that fails to take cognisance of any long-term trending the underlying valuation series may be experiencing.
Thus we prefer to use the linear regression mean as opposed to the simple average mean when it comes to looking at these kinds of charts. The simple average of the Schiller P/E is now 16.5, implying the current reading of 26.7 is alarmingly off-base. However the regression mean is 22.1 which paints a far less alarming picture:
If we draw parallel lines one standard-deviation either side of the regression mean, we get a better indication of what constitutes “nose-bleed” levels, represented by the red and green shaded circles. These represent once-in-a-decade extremes of over-valuation (red circle) or under-valuation (green circle).
Whilst there is no denying that the Schiller PE is showing we are currently in “historically expensive territory”, the regression lines show we are not yet in nose-bleed territory and there is easily more upside available in the stock market, at least according to this model everyone is trotting out.