In the world of market valuation metrics, few have gained as much prominence as the Shiller P/E Ratio, also known as the Cyclically Adjusted P/E (CAPE) Ratio. Made famous during the late 1990s tech bubble, this metric continues to be a valuable tool for investors seeking to understand market valuations and potential future returns.
What is the Shiller P/E Ratio?
Developed by Yale University Professor and Nobel Prize winner Robert Shiller, the Shiller P/E Ratio is a simple yet powerful calculation. It divides the current price of an index (typically the S&P 500 for US stocks) by the average earnings over the past 10 years. This approach smooths out short-term fluctuations and provides a more stable view of earnings across a full economic cycle.
Current Market Valuations
As of today, the Shiller P/E stands at around 37, approaching its second-highest level in history, surpassed only during the dot-com bubble. This elevated level has sparked considerable discussion among investors and market analysts.
Source: Multpl.com
The Value of the Shiller P/E
1. Projecting Long-Term Returns
The primary benefit of the Shiller P/E lies in its ability to project long-term market returns. Current elevated levels suggest below-average returns for US stocks over the next decade. For instance, Research Affiliates’ projections based on the current Shiller P/E indicate a nominal return of just 3.2% for US large-cap stocks over the next ten years.
2. Asset Allocation Insights
The Shiller P/E can also inform asset allocation decisions. While US stocks and bonds currently show low projected returns, other markets appear more promising. Emerging markets, for example, project an 9.0% annual return over the next decade, while developed foreign markets suggest a 8.6% return. This data may encourage investors to consider increasing their exposure to international markets.
Common Misuses of the Shiller P/E
Despite its value for long-term projections, the Shiller P/E is often misused when applied to shorter time frames. It’s crucial to understand that:
- The Shiller P/E has minimal predictive power for short-term market movements.
- It should not be used as a market timing tool for buying or selling decisions.
- A high Shiller P/E doesn’t necessarily mean an imminent market crash.
Variability of Returns
Even with low projected long-term returns, the path to get there can vary significantly. Consider these hypothetical 10-year return scenarios, all resulting in the projected 3.2% annualized return for US large-cap stocks:
- Strong initial years followed by weaker performance
- Consistent moderate returns throughout the period
- Initial negative returns followed by a strong recovery
These paths would feel very different for investors, and in path 1, investors who made reductions in their equity exposure would likely regret that choice. The variability of paths makes it very challenging to make real world decisions using something like the Shiller PE.
Keeping Perspective
The Shiller P/E, like all market data, is most valuable when used in the proper context. It excels at:
- Providing insights for long-term financial planning
- Guiding asset allocation decisions across different markets and asset classes
However, it falls short when used to predict short-term market movements or as a market timing tool.
The Pros and Cons of the Shiller PE
For long-term investors, the Shiller P/E Ratio remains a valuable tool in understanding market valuations and setting realistic return expectations. By using it appropriately – focusing on its long-term implications rather than short-term predictions – investors can make more informed decisions about their portfolio allocations and financial planning strategies.
Remember, successful investing requires a holistic approach, considering multiple factors beyond any single metric. The Shiller P/E is just one piece of the puzzle in building a robust, long-term investment strategy.
