One of the most popular valuation indicators for the S&P 500 is the Shiller P/E Ratio. The Shiller P/E Ratio (also known as CAPE or P/E 10 ratio) takes the S&P 500 and divides it by the 10 year average in inflation-adjusted earnings. It is commonly used to predict the stock market’s 10-20 year forward real returns.
Here is a chart, from 1881-2018.
The Shiller P/E ratio has two main flaws, the second which is more important than the first.
Problem #1: To smooth out erratic changes in corporate earnings, the Shiller P/E ratio takes a 10 year average of inflation-adjusted earnings. The problem is that a “10 year average of corporate earnings” is impacted by when those “10 years” begin. Here’s an example.
For the 10 year period from 2009-2018, corporate earnings would be weighed down by weak earnings from 2009.
For the 10 year period from 2010-2019, corporate earnings would “throw off” 2009 and no longer be weighed down by weak earnings in 2009.
Let’s assume that the S&P 500’s price is unchanged from 2018 to 2019. Under this scenario, the Shiller P/E ratio gives the illusion that the stock market’s valuation decreased from 2018 to 2019 when in reality, the only thing that changed was the “rolling off” of 2009’s weak earnings.
Problem #2 (more important): The Shiller P/E ratio is static. As you can see, the stock market’s valuations consistently peaked at a Shiller P/E of 20-25 from 1881 – 1995. But since 1995, the stock market’s P/E has been consistently higher. Someone who sold when Shiller P/E reached 25 in 1997 would have sold way too early. Moreover, the Shiller P/E has not mean-reverted to <10 as it has in the past 100 years.
Warren Buffett has said that interest rates have a big impact on the stock market’s valuations. Stocks compete with bonds as an asset class.
The inverse of the S&P 500’s P/E ratio is the S&P 500’s earnings yield. This corporate earnings yield competes with Treasury bond yields. Since stocks are riskier than bonds in the short run, the stock market must have a higher earnings yield in order to compensate investors for this extra risk.
Corporate earnings fluctuate less than the stock market’s price. Hence, the “price” must adjust in the long run to give stock market investors a satisfactory earnings yield (the “P” part of “P/E”)
- Interest rates in the 1970s were very high, which depressed the stock market’s valuations.
- Interest rates today are much lower than they used to be, which is why the stock market’s average valuations are higher than where they used to be.
A better P/E ratio
- Invert the Shiller P/E Ratio. E.g. if the Shiller P/E Ratio is 1/15, then the earnings yield is 1/15 = 0.0666 = 6.6666%
- Take a 10 year average of the U.S. headline inflation rate.
- Subtract step 1 – step 2
As you can see, this valuation indicator takes into consideration interest rates. As one would expect, whenever this valuation indicator fell to zero (i.e. stock market’s earnings yield = bond yield), the stock market’s valuation peaked. Stocks were priced too expensively to reward stock market investors for their extra risk.
Here is our valuation indicator (in blue) plotted against the S&P 500’s 10 year forward returns (including reinvested dividends, inflation-adjusted).
*Overall this is a good fit, except for the 1910-1920 period. The 1910-1920 period saw the stock market and corporate America impacted by WWI. As Ray Dalio has said in the past, wartime economies and stock markets are very different from peacetime economies and stock markets.