Shiller PE or CAPE
We all have our favourite valuation method. I like the Shiller PE method because it takes a long term view of the market and factors in earnings over a 1o-yr period, which is able to smooth out the different business cycles.Â
Valuations are particularly dangerous. I say this because valuations are what drive the market, and therefore they cannot be ignored. The fair value acts as a weak magnet that, over time, seems to get stronger. Time usually outlasts those fighting reality, with the winners being those who keep a longer time line in mind when using value.
The Shiller PE ratio, also known as the cyclically adjusted price-to-earnings (CAPE) ratio, is a valuation measure usually applied to broad equity markets, particularly the S&P 500 in the United States. It was popularized by Nobel Laureate economist Robert Shiller.
The formula for the Shiller PE ratio is:
Shiller PE Ratio= Price / 10-Year Average Real Earnings per Share
Where:
- Price is the current market price of the SP500 index.
- 10-Year Average Real Earnings per Share are the average earnings over the past 10 years, adjusted for inflation to today’s dollars.
In the chart below, I have included the SP500 on the left index as the blue line. I have included on the same chart the Shiller PE ratio on the right in index as the red line. I wanted both lines on the same chart to show the strong correlation in pricing between the 2 lines. (Note to self: as I write this, I realise that if I log scale the indexes, it would probably make the moves more proportional. and easier to see the relationship.)
What I have done in the next 3 charts is show a regression of future SP500 performance and the Shiller PE ratio. The lower the PE ratio (under valued) the better you expect the SP500 to perform. The higher the PE ratio (over valued – current situation) the worse you expect the SP500 to perform.
As you can see in the first chart with a 1-year future return the regression line is only marginally downward sloping. The second chart which is 5-yr future returns has an even steeper regression line. Finally the third chart which is the next 10-years has an even steeper regression line.
What this means is simply the longer your investment horizon the stronger the signal one can draw from the Shiller PE ratio.