The Market Is Overvalued by Historical Standards, but You Can Still Expect "Pretty Good" Returns

It's been hard to make sense of this market.

On one hand, Wharton Professor Jeremy Siegel went on CNBC last week and proclaimed that the Dow Jones Industrial Average (INDEX: ^DJI  ) will hit 17,000 in 2013. (It stands a little over 13,000 as of Thursday's market close.) Siegel told CNBC that this is "one of the cheapest stock markets I've seen." And the price data backs it up: The two leading stock market indices for U.S. stocks are trading at their lowest levels in at least four years.

Index	P/E Ratio	P/B Ratio
Dow Jones Industrial Average	14.5	2.3
S&P 500 (INDEX: ^GSPC  )	15.8	2.3

Source: S&P Capital IQ.

On the other hand, there are pundits like Andrew Smithers, who recently declared that U.S. stocks are as much as 71% overpriced.

Smithers believes the market to be overvalued based in part on a metric created by Yale Professor Robert Shiller called the cyclically adjusted price-to-earnings ratio, or CAPE. The CAPE divides the market's price by the average of a full 10 years of earnings -- thus correcting for the cyclicality of corporate earnings.

Last week, Professor Shiller stopped by Motley Fool Headquarters in Alexandria, Va., and sat down for an interview in our offices. I asked him whether the CAPE shows an over- or undervalued market -- watch the following video for his insights. (Scroll down beneath the video to see a transcript.)

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Brian Richards: Let's turn to the stock market for a second. In addition to the Case-Shiller Home Price Index, you're famous for the cyclically adjusted price-to-earnings ratio, the CAPE, which a lot of people like to use as a gauge for whether the market is over- or undervalued. What is the CAPE data telling you about the market's valuation today, after it has run up almost 100% in the last three years?

Robert Shiller: Well, the ratio of real S&P 500 to the real 10-year average earnings on that index is around 22, which is quite high by historical standards, because it was at 15 over the whole century preceding. But it's not super high. It got up to 46 in 2000. At this level -- I wrote a paper with John Campbell and we actually presented it at the Federal Reserve Board in 1996 -- at that point, the analysis we did suggested that historically, when the price-to-earnings ratio is 22, then the expected return on the stock market is, real return, is something like, I don't know, in the range of 4% a year, which is below the historical average, which is more like 7% a year. So it's not as good as normal, but it still is pretty good. And so I'm thinking that stock market investments are still sensible portfolio investments. Not aggressively, but as part of a diversified portfolio.

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