Yale professor Robert Shiller has been one of the many market watchers warning of lofty valuations in assets this summer, but one research firm has detailed how his own economic indicator could actually be signaling a strong period ahead for equities over the next 12 to 18 months.
Charles Dumas, the chief economist at London-based forecasting consultancy Lombard Street, believes that the cyclically adjusted price to earnings (CAPE) ratio can support both bullish and bearish views. This ratio - which Shiller helped to create - measures the S&P 500 (^GSPC)'s average inflation-adjusted earnings over the previous 10 years.
Dumas argues that including the Great Depression, two world wars and the Cold War into the long-run average makes it an "unduly poor comparator". Instead, if you disregard this period, the CAPE is only 7 percent above the post-Cold War average, according to Dumas.
"From such a level, the growth of U.S. profits and the inflow of funds to U.S. markets from much of the rest of the world hold out the promise of (a) significant further stock market advance," he said in a research note on Thursday. Dumas also suggests that another metric, also documented by Shiller, the S&P real value index is showing signs of significant potential upside for the bourse and is close to its long-run trend.
"What do we expect? For the next 12-18 months, barring major war(s), a significant rise in the index," he added.
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On August 19, Shiller told CNBC that his CAPE ratio stood at 25, a level that has been surpassed only three times since 1881 - the years surrounding 1929, 1999 and 2008. The ratio averaged 15.21 in the 20th century and stood at 23 last year. He warned on the valuation of U.S. stocks, bonds and housing and sent ripples through global markets.
Dumas' analysis adds to criticism by Jack Boroudjian, the chief investment officer at Index Financial Partners, who told CNBC that Shiller's warning was unwarranted and believed that he uses a "strange equation". He predicted that stocks had much further to run.
Despite questions surrounding the calculations, Shiller could hardly be described as a contrarian. A growing chorus of naysayers has warned of a potential correction - or something even worse - in the S&P 500. Societe Generale's uber-bearish strategist Albert Edwards said on Thursday that a bubble in stock markets is on the verge of bursting with the S&P 500 now "running on fumes." Meanwhile, David Tice, president of Tice Capital and founder of the Prudent Bear Fund, told CNBC on Wednesday that markets could soon face a fall of up to 60 percent with the most likely cause being disillusionment with the Federal Reserve 's policy guidance.
Beat Wittmann, the CEO of TCMG Asset Management, remains cautious in the near term, believing that stocks are in for a period of volatility. Ultimately, investors shouldn't fight an equity rally in the U.S. and Europe that he believes is being fueled by accommodative policies from central banks, he said.
"You should be very, very careful in being tactical," he told CNBC Friday, but added that he was convinced that markets will see significantly higher equity prices over the next three to five years.