Is The Shiller P/E Broken?

by: Acting Man

By Chris Hunter

One of the water-cooler conversations at Bonner & Partners is whether the Shiller P/E - the valuation ratio popularized by Yale economist Robert Shiller - is worth a damn. If you're not already familiar with the Shiller P/E, here's a quick introduction…

The standard price-to-earnings ratio looks at a company's share price compared to its per-share earnings. And it either looks at per-share earnings from the last four quarters (known as the trailing P/E)… or from the expected per-share earnings for the next four quarters (known as the forward or projected P/E).

The Shiller P/E works a little differently. Instead of dividing stock prices by per-share earnings over the preceding 12 months or using per-share earnings estimates for the next 12 months, it divides stock prices by the inflation-adjusted earnings over the preceding 10 years.

According to Shiller, his measure (also known as the CAPE, which stands for "Cyclically Adjusted Price-Earnings"):

…does so to help minimize effects of business-cycle fluctuations, and it's helpful in comparing valuations over long horizons."

Writing in the New York Times on Saturday, Shiller added that:

In the last century, the CAPE has fluctuated greatly, yet it has consistently reverted to its historical mean - sometimes taking a while to do so. Periods of high valuation have tended to be followed eventually by stock-price declines."

And as you can see from the chart below of the CAPE for the S&P 500 going back to the late 19th century, a CAPE reading of 20 or above would have warned you of trouble in the late 1920s (ahead of the 1929 crash)… the late 1960s (ahead of the big plunges in the 1970s)… in the 1990s (ahead of the dot-com crash)… and in the run-up to the 2008 crash.


Shiller P/E, a.k.a. CAPE - Source:

And today, the CAPE seems to be sending another warning signal. At writing, the S&P 500 trades on a CAPE of 26.2. That's 72.3% above its 20th-century average of 15.21.

As Shiller notes:

It's a level that has been surpassed since 1881 in only three previous periods: the years clustered around 1929, 1999 and 2007."

And as we know, major market drops followed these peaks. That's all pretty clear, then, right? Not so fast…

As Shiller's critics point out - and as he freely admits - the CAPE ratio has been a very imprecise timing indicator. Most notably, it's been relatively high - above 20 - for almost all the last 20 years, with the exception of 20 months, mostly in the recession of 2007-09, when prices tumbled and it fell as low as 13.3 (a strong buy signal). Shiller gives a number of possible explanations for this high reading in the face of rising stock prices.

The first (and most likely) are the unusually low yields on Treasury bonds. When Treasury yields are low, stocks look more attractive on a relative basis. For example, if you can only earn 2% a year on a 10-year, then 4% a year in stocks looks pretty good. But if you can earn 4% a year on a 10-year T-note, that 4% on more volatile stocks starts to look a lot less enticing.

Another possible explanation is that Mom & Pop investors are being pushed into investing in stocks by fears of stagnant - even declining - wages… even if they are overvalued. Others reckon that the collapse in earnings in the 2008-09 crash has skewed the ratio higher.

Of course, the whole point of the CAPE is to smooth out these fluctuations. In 2008, there was a big collapse in US corporate earnings. So, in 2009, had you looked at just 12 months of reported earnings, you would have concluded that stocks were massively overpriced, when in fact they proved to be a bargain. (On January 1, 2009, the S&P 500 traded on a trailing P/E of 70.9.)

So, what should you take away from all this? I recommend the following three simple steps:

1. Accept that no measure of value is perfect. Nor is any measure of value a perfect timer of market tops or bottoms.

2. Never panic sell. Bill's investing motto is: "Think a lot… Do very little." If you buy stocks at steep enough discounts to your estimates of their intrinsic values… and hold on until they reach those estimates… you'll do better than 99% of investors over the long run. Trading in and out of positions will almost certainly leave your poorer. If your bad guesses don't get you, your transaction fees will.

3. Don't just invest slavishly in the US. Think internationally. And favor cheap stock markets over expensive ones.

Mebane Faber of Cambria Investment Management has done back tests on a simple strategy of each year buying the cheapest stock markets in the world ranked by the CAPE. And variations of this strategy returned between 15.9% and 17.6% per year, compounded annually, from 1980 to 2013.

Of course, right now, this strategy would mean buying stocks in places like Russia, Greece, Argentina and Ireland… and having the discipline to stick with those positions. Not everyone is capable of that kind of discipline. But history suggests that those who are will be rewarded.

The above article is from Diary of a Rogue Economist originally written for Bonner & Partners.