Is the P/E ratio above its trend? Defining trend differently aids in analysis: Cleveland Fed study
Using a moving average for the trend helps in analyzing whether the P/E ratio is above its trend, say Cleveland Fed researchers
CAPE levels look high relative to their long-run average level, but don’t look particularly high relative to the HP filter moving average value
The price-to-earnings or P/E ratio has proven useful in the past for detecting when stock markets are overvalued and headed for a correction. However, since the early 2000s, the economy may have changed structurally; for example, the types of jobs that are available or the industries that are driving growth may now be different than in the past. These factors need to be taken into account when assessing what is “normal” or “overvalued” in today’s markets, say researchers from the Federal Reserve Bank of Cleveland. They say a moving average representation of the P/E ratio allows them to better analyze whether the P/E ratio is truly above its trend.
Using a variant of the P/E ratio that was created by Yale economist Robert Shiller, the Cyclically Adjusted Price-to-Earnings ratio (CAPE), the researchers analyze the position of the CAPE relative to its trend, using two different definitions of the trend: the long-run average level of the CAPE and a moving average, created using a Hodrick-Prescott (HP) filter.
According to the researchers, recent CAPE levels look high relative to their long-run average level, but they don’t look particularly high relative to the HP trend. The researchers note that CAPE is only slightly above its HP filter moving average value.
For more details, see Comparing Price-to-Earnings Ratios: The S&P 500 Forward P/E and the CAPE
Federal Reserve Bank of Cleveland
The Federal Reserve Bank of Cleveland is one of 12 regional Reserve Banks that along with the Board of Governors in Washington DC comprise the Federal Reserve System. Part of the US central bank, the Cleveland Fed participates in the formulation of our nation’s monetary policy, supervises banking organizations, provides payment and other services to financial institutions and to the US Treasury, and performs many activities that support Federal Reserve operations System-wide. In addition, the Bank supports the well-being of communities across the Fourth Federal Reserve District through a wide array of research, outreach, and educational activities.
The Cleveland Fed, with branches in Cincinnati and Pittsburgh, serves an area that comprises Ohio, western Pennsylvania, eastern Kentucky, and the northern panhandle of West Virginia.
Doug Campbell, firstname.lastname@example.org, 513.455.4479