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Using 5-Year Shiller PEs To Influence Risk Profiles

Apr. 11, 2018 8:59 AM ET1 Comment
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Long-Short Manager


  • We look at data from 1871 through 2009 to examine how valuation quintile affects subsequent long-term returns.
  • For a long-term investor (10-years or longer) dollar-cost averaging tends to dominate all strategies, even in the richest valuation quintile, primarily due to the late 1990s period.
  • Over 1 and 3 year time horizons, the impact of valuation is more pronounced on the distribution of subsequent returns.

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Below (Figure 1) we look at something called a 5-year P/E, using the S&P500. This basically takes the average of the last 5-years of earnings on the index as the denominator, and the price of the index at the end of that 5-year period as the numerator. If you think about the index as representing the entire economy, this basically tells you what multiple the market is offering economic profits at. The reason to use a 5-year P/E is that this tends to smoothen out the economic and profit cycles so you get a more stable sense of where profits are selling. For example, a P/E multiple of 10 would correspond to economic profits of $1 selling for $10; said another way, you could spend $10 to earn $1 of profits per year, meaning a 10% earnings yield (so E/P, the reciprocal, would be the 5-year earnings yield).

This is the historical pattern, with percentile lines drawn in for the 20th,40th,60th and 80th percentiles of the valuation level.

A P/E(5) of 10.6 or cheaper has only been offered 1/5 of the time; interestingly, these are all times of economic turbulence and worry: the great deflation and panics of the 1870s, multiple recessions, WWI, the great depression, WWII, the inflationary early 1980s, and most recently, March 2009. The other percentile lines correspond to P/Es of 13.8, 16, and 19.3. There is considerable evidence that sales are followed by mark-ups and mark-ups by sales, with the timescales of transitions on the order of a decade or so (between the cheapest and most expensive quintiles, anyway).

This article was written by

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I run two funds, one a diversified global income fund targeting about a 4-4.5% annual withdrawal rate for life, and a long-short aggressive fund that is a global cross asset class fund.

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