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Stock market and investing has been gripping many young adults these days and the first thing that anybody entering investing learns of, is the price to earnings ratio or PE ratio. It is a preliminary criteria but it is not sufficient to take investment decisions on a standalone basis. However, the importance of the ratio could not be kept aside as it gives an initial thought on market perception of the investment under study.

To take care of seasonal variations and other short term earning discrepancies, Yale professor Robert Shiller constructed a PE ratio which is inflation adjusted and the earnings are averaged for 10 years. Prof. Shiller gained his popularity by creating a housing price index for U.S. home prices, known as the Case-Shiller index, which is one of the most followed index worldwide to observe real estate prices in U.S.

The concept of Shiller PE ratio is known by various names like cyclically adjusted PE or CAPE, PE10 and most popularly by Shiller's PE. Shiller's PE has been calculated and interpreted by many, for S&P 500 index for decades. The current Shiller PE for S&P 500 is ~23. It is 44% higher than the ratio's long-term average of ~16. Some school of thoughts, interpret it as an indication that current market prices of S&P stocks are very high and may be overvalued.

We did a study and tried to apply the Shiller PE methodology to various economies across geographies. We took major stock indices FTSE 100 (U.K.), Nikkei 225 (Japan), CAC 40 (France), Dax (Germany), S&P/ASX 200 (Australia), SMI (Switzerland), Shanghai Composite (China), BOVESPA (Brazil), KOSPI (South Korea), TAIEX (Taiwan) and SENSEX 30 (India) for the study.

According to the findings, the developing countries like India and China are trading at mean Shiller PE of 24.78 and 30.38. India is trading high on export of services and on the domestic consumption story while China on other hand, is trading high on export driven growth. However, the ratio of China is trending rapidly down, which shows the outlook for the growth in the country slowing down. The Indian Shiller PE, by contrast, remained in a range and has the trend indication also to remain range bound.

If we look at the other two economies among the BRIC or developing countries, Brazil and Russia, Russia seems to be trading lower on a Shiller PE basis. In fact, at a mean Shiller PE of 8.5, it is trading at lowest PE among all major economies. Despite being coined in BRICs, the investor perception for Russia is of a risky economy and this resulted in the lowest PE among all the countries. Brazil on other hand had been trading near a Shiller PE of 25 for some time, but now it is also trending down has reached 18. This seems to be the effect of investor redemptions. Brazil is a commodity driven economy and as commodity prices are hit, so too will investor capital.

Among developed markets, the U.K., Australia, Switzerland and South Korea were trading in a similar Shiller PE range of 17-20 for last three years. Germany is trading on higher side with Shiller PE of 23 which is similar to the current U.S. Shiller PE, and France on lower side with Shiller PE of 12.

Japan is an exception among the developed market and is trading at a globally high Shiller PE of 37. After losing a decade due to deflation, one might think that its P/E should have been among the lowest. However, one reason for higher PE is that, the earnings of Japanese companies fell faster than their stock prices. Another reason for Japan to be higher on Shiller PE is of interest rates. For more than a decade, Japan had near zero interest rates. Low interest rates have almost always resulted in higher PE ratios.

If we compare the current Shiller PE with historical average Shiller PE of the Indices, it is found that India, China, Brazil and U.K. are trading at a significantly lower Shiller PE than their historical average Shiller PE by 8-18%. India being at 8% discount and Brazil being at 18% discount. However, if current normal PE is compared with the current Shiller PE of the indices, most of the indices show a 20-50% discount except for India, Russia, France, Australia and South Africa, due to the recent fall which is reflected in the current PE but smoothened in the longer term inflation adjusted, Shiller PE.

When we observe the Shiller PE for various geographies, we can see that being a long term measure of valuations, it shows that world economies are interdependent and move in a similar trend. There have been many arguments against using Shiller PE to value markets. However, in my opinion, applying that to get a smooth trend for various economies could help portfolio managers to have an initial idea on which way their portfolio should be weighed.

Source: World Equity Valuations by the Shiller PE Ratio