The Story of the Week: The Schiller P/E Hits 30
Party Like It’s 1929 (or 1999)
Long-Term Chart Shiller P/E Ratio of US Stocks
The Cyclically Adjusted P/E ratio (CAPE) is one of the most reliable valuation metrics out there. It was designed by Robert Shiller, writer of the must-read book Irrational Exuberance, hence it is also called the Shiller P/E. The Shiller P/E It is widely used to judge the overall valuation “environment” of a stock market, with a great track record. It’s based on the traditional Price/Earnings ratio, but instead of one year’s earnings, it is calculated by using the 10-year average of earnings. This metric has a very high correlation with long-term (7-10 years) returns, but it has been attacked by experts constantly, as its short-term value is questionable.
The most disturbing thing about this indicator for the sell-side media is that it is currently right at 30 in the US, exactly at the same level as before the crash of 1929. The only time when the ratio was higher than this was towards the end of the dot-com bubble, and we all know how that ended. That said, this measure is far from being a timing tool, and in the 90’s stocks continued higher for a long time before finally turning lower after the bursting of the bubble.
But what does that mean to you? To put it simply, stocks are expected to deliver returns a little bit over 0% in the next ten years. With a high probability, you can count with no returns whatsoever from you passive stock holdings. Also, if we compare that to the usual 10%/year assumptions regarding stocks, it’s apparent just how overvalued the US market is. But before you jump into shorts straight away remember that stocks almost doubled at the end of the dot-com mania even from these overvalued levels. That said, hedging your long-term bets or looking for alternative investments might be a wise idea, especially of you have a huge exposure to stocks.