This single stock market infographic is perhaps the biggest selling point for Robert Shiller’s method. It clearly outlines that when the Shiller P/E has been high, the market has done poorly– and vice versa.
In this post, contributor Andy Shuler introduces Robert Shiller and also presents a great chart showing how the Shiller P/E has been less volatile than the regular P/E.
Shiller P/E and the Stock Market (Infographic Link)
Who is Robert Shiller and what’s the Shiller P/E?
Introduction to One of the Most Popular Stock Market Valuation Ratios
Robert Shiller is a very famous economist from Yale who wanted to develop a method to measure whether a stock was under or over valued by comparing against a much longer history than the normal year that is used when evaluating a stock’s Price to earnings (P/E) ratio.
Shiller decided that the best way to do this was to use a period of 10 years and adjust it to inflation, to then determine the PE.
This method is commonly referred to as the Cyclically Adjusted Price-to-Earning ratio (CAPE), or the Shiller P/E.
Essentially what this does is it takes out a lot of the volatility that you might see during economic booms and busts. During a recession, most consumers discretionary spending is halted, leading to decreased earnings from many companies.
In a normal P/E ratio, two quarter of bad earnings is ½ of the earnings represented in a normal P/E ratio but in Shiller’s P/E ratio, it’s only 5% (2/40 quarters).
To take it back a step, I want to explain the P/E ratio a bit before we get too far into Shiller’s Method.
The Basics of the P/E Ratio
The P/E is essentially how expensive a stock is. It is a very easy formula to understand as it’s the stock price/earnings per share. The higher the P/E ratio, the more expensive the stock is.
For instance, (yes, I know this is a veryyy basic example with no other background at all) if you had the choice to buy a stock with $5 earnings/share (EPS) for $50, or to buy a different stock with $5 EPS for $100, which would you buy?
Hopefully you’d buy the stock that had the $50 share price as the P/E is 10 ($50 price/$5 earnings) instead of the other stock with the P/E of 20 ($100/$5). Essentially, this is saying that you’re going to get a stock for half of the price as the other stock.
The Infographic below really is a great way to explain not only why P/E is such an important measure, but why Shiller’s method is also an extremely reliable way of measuring how over/undervalued the stock market is in general.
As you can see, there’s really four picture perfect time periods that show that the lower the P/E, the higher the returns had been 5, 10 and 20 years out from that point.
This is occurring because you’re buying cheap, undervalued stocks. And those stocks have been undervalued for quite some time because you’re taking out a lot of the volatility by using ten years of earnings and also adjusting for inflation.
Shiller’s P/E has had less volatility than the market’s regular P/E…
In addition to great returns, Shiller’s method can help reduce the high volatility that can lead to bad decision making when investing in the market.
Since 1950, the average P/E volatility of the S&P 500 realized a variance of 20.69% vs. the prior year while Shiller’s Method has only realized a variance of 12.86%. Don’t believe me? See below:
Shiller P/E vs Volatility Chart (Link)
I think a perfect example is to think of what has happened the last month or so with the trade war. The S&P 500 has dropped 7% as of Monday and this has almost solely been due to the trade war tensions.
Was the market overvalued prior to that drop?
Eh… yeah… probably.
But the point is by just a few tweets from the POTUS, and some tariffs on China and Mexico, and China not backing down, the market has really snapped back recently.
Does that mean that this might be a great time to buy?
But also, maybe not.
A lot of people view this as a “cheap” time to get into the market but that might not be true – the market might still be overvalued.
According to Shiller’s Ratio, the P/E as of 6/5 was still over 28, which also happens to be the 5th highest annual P/E of the last twenty years (using data on 1/1 each year)!
Andrew and Dave frequently say on the podcast: “invest with a margin of safety…emphasis on the safety”, and there really is not better way to do that then if you can reduce some volatility in the market and look at the market as a whole, over the course of a long time, rather than just certain economic downturns.
All in all, sounds like Shiller knows what he’s talking about.