Quick Bite | Shiller P/E model sends a warning sign about US market

The Shiller P/E ratio is presently at a high 30.19x, perhaps an indication that the US share market is seriously overpriced. The Shiller P/E is named for American economist Robert J Shiller, and is a cyclically adjusted price-to-earnings ratio. It is also known as the CAPE (Cyclically Adjusted Price Earnings) ratio.

It is a variant of the more popular price to earnings ratio (which typically looks at next year’s forecast earnings) and is calculated by dividing the current price of a stock by its average inflation-adjusted earnings over the last 10 years. Using average earnings over the last decade helps to smooth out the impact of business cycles and other events and gives a better picture of a company’s sustainable earning power.

As such, it is principally used to assess likely future returns from equities over timescales of 10 to 20 years, with higher than average CAPE values implying lower than average long-term annual average returns.

The maximum the Shiller P/E has ever been measured at is 44.19x, from the height of the DotCom Bubble back in 2000/1. The mean is 17.03x, suggesting that at 30x we’re at elevated valuations, particularly given rising interest rates.

Source: MacroVisor 


The ratio can be used to gauge whether a stock (or group of stocks) is undervalued or overvalued by comparing its current market price to its inflation-adjusted historical earnings record. But it is not useful as a market-timing tool unless one has a very long timeframe in mind.

Like many other valuation metrics, the Shiller P/E ratio is limited in its scope: it is backward-looking, based on historical performance figures, and if a company or market is rapidly evolving or fundamentally changing, its utility will be minimal.

Shiller himself has proposed an alternative calculation based on recent changes in corporate payout practices. For example, many companies have moved toward share repurchases rather than dividends as a way to distribute cash to shareholders. Widespread use of this payout mechanism can impact the average earnings per share (EPS) figures used to calculate the Shiller P/E. To account for this, Shiller now proposes a total return CAPE that reinvests dividends into the price index.

Other research has suggested that using the Shiller P/E to forecast equity returns could yield overly pessimistic results based on changes in generally accepted accounting principles (GAAP) methods for calculating earnings. Jeremy Siegel from the Wharton School of Business suggests that using operating earnings instead of GAAP earnings may enhance the predictive power of the Shiller P/E.

The Shiller P/E is interesting and useful but should not be relied upon in isolation. There are few shortcuts to deep and comprehensive analysis when it comes to sensible investing. Like the old saying goes, sometimes shortcuts get you nowhere faster.



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