By Tobias Carlisle
Earlier this week I posted about the current controversy around the cyclically-adjusted earnings in the Shiller PE, most notably that the real earnings used in the Shiller PE are lower than they would otherwise be because of two serious earnings recessions.
Another question about the Shiller PE is how accurate it has been historically as a forecasting tool. Asness has backtested the performance of the market from various Shiller PE starting points from 1926 to 2012, finding as follows:
Ten-year forward average returns fall nearly monotonically as starting Shiller P/Es increase. Also, as starting Shiller P/Es go up, worst cases get worse and best cases get weaker (best cases remain OK from any decile, so there is generally hope even if it should not triumph over experience!).
The Shiller PE at the time of Asness’s article was 22.2, and the current Shiller PE is 23.4. Both are squarely in the middle of the highlighted row:
If today’s Shiller P/E is 22.2, and your long-term plan calls for a 10% nominal (or with today’s inflation about 7-8% real) return on the stock market, you are basically rooting for the absolute best case in history to play out again, and rooting for something drastically above the average case from these valuations. This could happen. For instance, it could happen if total real earnings growth surprises to the upside by a lot for a very long time. But unless you are comfortable with forecasting that, or some other giant positive surprise, we believe one should give credence to the lower forecasted average returns from history. While market timing might not be the answer, changing your plans — assuming a lower expected market return, perhaps saving more or spending less, or making changes in your portfolio structure — are all worth serious consideration. I think the Shiller P/E is quite meaningful for planning.
Asness examines several other interesting market-level valuation metrics, finding that they tend to support the implications of the currently elevated Shiller PE, noting:
Some outright hucksters still use the trick of comparing current P/Es based on “forecast” “operating” earnings with historical average P/E’s based on total trailing earnings. In addition, some critics say you can’t compare today to the past because accounting standards have changed, and the long-term past contains things like World Wars and Depressions. While I don’t buy it, this argument applies equally to the one-year P/E which many are still somehow willing to use. Also it’s ironic that the chief argument of the critics, their big gun that I address exhaustively above [from the earlier post], is that the last 10 years are just too disastrous to be meaningful (recall they are actually mildly above average).
While it’s indeed important to remember that no valuation measure is near perfect (I stress that in my initial table), I do believe that the Shiller P/E is a reasonable method, an unbiased method (it’s been 15+ years since it was created so nobody cherry picked it to fit the current period), and a method that is decidedly not “broken” based on today’s inputs. It has very limited use for market timing (certainly on its own) and there is still great variability around its predictions over even decades. But, if you don’t lower your expectations when Shiller P/Es are high without a good reason — and in my view the critics have not provided a good reason this time around — I think you are making a mistake.
The current Shiller PE of 23.4 implies a real return of less than 0.9 percent per year for the next decade, with a best-case scenario less than 8.3 percent annually, and a worst-case scenario of less than -4.4 percent annually.