What is the Shiller P/E Ratio telling you

Prof. Robert ShillerP/E Ratio

Dear PGM Capital, Blog readers,
In this midweek and Christmas blog article we want to discuss with you the shiller PE ratio and what this ratio is telling you right now.

Professor, Robert James “Bob” Shiller is an American economist, academic, and best-selling author. He currently serves as a Sterling Professor of Economics at Yale University and Yale School of Management.

In September 2007, almost exactly one year before the collapse of Lehman Brothers, Shiller wrote an article in which he predicted an imminent collapse in the U.S. housing market, and subsequent financial panic.

On 14 October 2013, it was announced that Robert Shiller, together with Eugene Fama and Lars Peter Hansen, would receive the 2013 Nobel Prize in Economics, “for their empirical analysis of asset prices”

The Shiller P/E ratio:
Prof. Robert Shiller invented the Schiller P/E ratio to measure the market’s valuation.

The Schiller P/E is a more reasonable market valuation indicator than the P/E ratio because it eliminates fluctuation of the ratio caused by the variation of profit margins during business cycles.

The Shiller P/E ratio is computed by taking the current price and dividing by the average inflation-adjusted earnings from the previous 10 years. This measurement is also known as the cyclically adjusted PE ratio (CAPE ratio), or P/E 10.

Why is the Shiller P/E ratio a better indicator than the regular P/E:
The regular P/E uses the ratio of the S&P 500 index over the trailing-12-month (t.t.m. P/E) earnings of S&P 500 companies. During economic expansions, companies have high profit margins and earnings. The P/E ratio then becomes artificially low due to higher earnings. During recessions, profit margins are low and earnings are low. Then the regular P/E ratio becomes higher.

Using 10 years of earnings allows movements in price to play their important role in market cycles. After price has fallen but before earnings have recovered is the best time to invest. The t.t.m. P/E ratio will still look bad, but the P/E 10 will be signalling a buy.  Similarly, when the markets are doing well and the last year of earnings makes it look like P/E t.t.m. ratios are attractive, the P/E 10 will be signalling you to consider trimming stocks that now look expensive.

The highest peak for the regular P/E was 123 in the first quarter of 2009. By then the S&P 500 had crashed more than 50% from its peak in 2007. The P/E was high because earnings were depressed. With the P/E at 123 in the first quarter of 2009, much higher than the historical mean of 15, it was the best time in recent history to buy stocks. On the other hand, the Shiller P/E was at 13.3, its lowest level in decades, correctly indicating a better time to buy stocks.

See below chart for details.

S&P-500 t.t.m. P/E ratio

The main reason for us to interrupt our yearend vacation to write this blog article is due to the fact that on, Monday December 23 2013, the Shiller P/E ratio closed at a 5 year high of 26.11, approx. 58.4% higher than its historical mean of 16.5 as can be seen from below chart.

Shiller P/E -10 ratio

Today’s, December 23rd, 2013, value of the Shiller P/E ratio of 26.11, is more or less at the same level as it was in 2008 when we saw a sharp decline in the stock markets.

As can be seen from above chart, every time the Shiller P/E was above the 22-24 level the market either corrected sharply or it went into a long cycle of systematical decline. Credit Suisse made below chart, in which they place the 3 year average market return based on several Shiller P/E ratio scenarios.  As can be seen from below chart the current Shiller P/E ratio of 26.11 predicts a negative average market return for the coming three years.

Average 3 year return per shiller index

On top of this, as we can see from below chart, the yield of the 10-year note closed on December 23, 2013 at a 2-year high of 2.93% which means that investors are already fleeing the USA-bond market, rising interest rates will have a negative effect on the real-estate market as well.

2 year 10-year note chart

With money flowing out of the stock and bond market, it leaves us with only the commodity and precious metals market in which we can expect a bull market for 2014. With increasing world population we expect a structural food and fresh water shortage and subsequent price inflation in the coming years.

Some media will try to cool the nerves by telling you, that there is nothing to worry about, because, currently we are living in a totally different world and due to this, THIS TIME IT WILL BE DIFFERENT.

Ladies and Gentlemen, the rule of money and behaviour capital markets are time-less, it is never different. Capital Markets are mainly dominated by the human emotions of GREED and FEAR, for which the FEAR emotion is much stronger than the Greed factor. This is the main reason why they say on wallstreet, that the BULL comes up by the stairs and the BEAR goes down by the window.

We hope to have informed you satisfactorily and wish you and your family Happy Holidays

Yours Truly

Eric Panneflek

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