In a recent piece for Advisor Perspectives, Keith C. Goddard, CFA, presents some intriguing data on how investors might use the 10-year “Shiller” P/E ratio to adjust their exposure to equities.
In the article, Goddard measures the distributions of returns that have followed various starting-point valuation levels in the stock market using the 10-year P/E, which was pioneered by Yale economist Robert Shiller. Looking at every three-year period (measured by month-end) going back to 1884, he finds that the average annualized return for those 1,506 rolling 36-month periods has been 10.63% for the broader market. About one in seven times (15.1%), a three-year return has been negative.
Goddard then split the three-year periods into quartiles based on the 10-year P/E at the start of the periods. The highest quartile involved three-year periods that began when the 10-year P/E was 19.2 or higher; the lowest involved 10-year P/E starting points of 11.54 or lower.
For the lowest quartile periods, the average annualized return was 17.03%. None of those three-year periods featured negative annualized returns.
For the highest quartile periods, the average annualized return was just 7.07%. And 28.1% of the time, the period involved a negative return.
Goddard says the data presents key questions for investors and financial planners, such as “Do professionals do their clients a disservice if they offer similar advice about stocks regardless of whether the starting P/E ratio is high or low, as so many financial software platforms prescribe?”
“The evidence from the real-world history of asset markets suggests that market returns are not totally random,” Goddard concludes. “It is our job as investors to pay attention and adjust our wagers accordingly.”
One interesting note about Goddard’s findings: According to Shiller’s own monthly data, the 10-year P/E has not fallen into that bottom historical quartile (below 11.54) since November of 1985.