Wednesday, October 28, 2009

Correlation, correlation but where art thou causation

This chart is produced from a data set kept by Yale and Robert Shiller. It shows the 10 year price earning ratio in a scatter chart plotted against the actual 10 year return.

It looks like it could be follow a logarithmic or power law function, and is definitely not linear.

However, we can see that as the PE level is lower the returns are higher. So I made another chart just showing the different levels of PE <5,>25. Here it is.

So while each section has a considerable range between its high and low points, you see lower highs and lower lows as you move from left to right. So this Shiller might be on to something.

Currently Mr. Shiller's has us at 19.48, at the market low in March we briefly nuzzled 13.32 so in the 6 month expansion we have seen the multiple increase by 6x!!!

Last chart

So you can see the bubbles like in 1929 and 2000 were all caused by multiple expansion, as they correlate tightly in those periods. However, in more recent times (2003 - 2007) you can see that earnings kept growing while the price of the index rose in accordance [the P/E line is flat while the red index line moves upward] Finally, as I stated above this last move seems to be all about the multiple expansion as opposed to real growth prospects.

I'd be happy to keep up momentum trading for awhile, even after this week's set back but I think we will test the 750 level again before the Great Recession is over.

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