Shiller PE – A Better Measurement of Market Valuation

Buffett Indicator; How to Know the Current Market is Expensive?

Shiller PE: How to Know the Current Market is Expensive?

Top 10 Economic Indicators

1. The Dow Jones Industrial Average (DJIA)
2. SP 500 Index
3. Nasdaq Composite Index
4. Gross Domestic Product (GDP)
5. Shiller PE
6. Ratio of Wilshire 5000 over GNP
7. Civilian Unemployment Rate
8. Russell 2000 Small Cap Price Index
9. CBOE Volatility Index (VIX)
10. Total Nonfarm Payrolls: All Employees

Stocks: Losers and Gainers

StockPrice Price Change
BSTC$ 88.69$27.67 (45.35%)
RESI$ 13.44$3.48 (34.94%)
OBCI$ 16.44$2.80 (20.53%)
AAMC$ 23.87$3.95 (19.83%)
SMMC$ 11.96$1.61 (15.56%)
AEL$ 27.49$-4.81 (-14.89%)
LTRN$ 17.59$-2.19 (-11.07%)
BCLI$ 12.37$-1.49 (-10.75%)
RAPT$ 36.61$-4.26 (-10.42%)
HGEN$ 13.44$-1.56 (-10.40%)

Market Overvalued, How to Invest?

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Date: Mon, 19 Oct 2020 23:07:53 -0500 (Updated every 10 minutes)

Shiller PE: 29.8 ( -1.633%)

Shiller PE is 16.2% higher than the recent 20-year average of 25.6
Implied future annual return: 1.8%
Recent 20-year low: 13.3
Recent 20-year high: 39.4
S&P 500: 3426.92
Regular PE: 35.5 (Recent 20-year average: 25.5)

Note: Starting from 06/26/2020, when calculating the implied future return, instead of assuming that over the long term the Shiller PE of the market will reverse to its all-time historical average, we will change it to reverse to its recent 20-year average.

Shiller PE

Prof. Robert Shiller of Yale University invented the Shiller PE Ratio to measure the market's valuation. The Shiller PE is a more reasonable market valuation indicator than the PE ratio because it eliminates fluctuation of the ratio caused by the variation of profit margins during business cycles. This is similar to market valuation based on the ratio of total market cap over GDP, where the variation of profit margins does not play a role either.

GuruFocus calculates the Shiller PE ratio of individual stocks and different sectors. Here you can see the Sector Shiller PE, it shows you which sectors are the cheapest. Here you can see Shiller PE of individual stocks.

How Is the Shiller PE Calculated?

  1. Use the annual earnings of the S&P 500 companies over the past 10 years.
  2. Adjust the past earnings for inflation using CPI; past earnings are adjusted to today's dollars.
  3. Average the adjusted values for E10.
  4. The Shiller PE equals the ratio of the price of the S&P 500 index over E10.

Why Is the Regular PE Ratio Deceiving?

The regular PE uses the ratio of the S&P 500 index over the trailing-12-month earnings of S&P 500 companies. During economic expansions, companies have high profit margins and earnings. The PE ratio then becomes artificially low due to higher earnings. During recessions, profit margins are low and earnings are low. Then the regular PE ratio becomes higher. It is most obvious in the chart below:

Regular PE Ratio

The highest peak for the regular PE ratio 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 PE ratio was high because earnings were depressed. With the PE ratio 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 PE ratio was at 13.3, its lowest level in decades, correctly indicating a better time to buy stocks.

Shiller PE Implied Market Return

If we assume that over the long term, the Shiller PE of the market will reverse to its recent 20-year average of 25.6, the future market return will come from three parts:

  1. Contraction or expansion of the Shiller PE to the recent 20-year average
  2. Dividends
  3. Business growth

The investment return is thus equal to:

Investment Return (%) = Dividend Yield (%) + Business Growth(%) + (Mean_Shiller_PE/Current_Shiller_PE)(1/T)-1

From this we will estimate that at the Shiller PE's current level, the future market return will be around 1.8% a year. This is the historical implied return, actual return and long term interest. Interest rate does have an impact on the market returns. Click on the legend of the chart below to show/hide chart series.

Shiller PE Implied Market Return

In reality, it will never be the case that Shiller PE will reverse exactly to the mean after 8 years. Table below give us a better idea on the range of the future returns will be if the market are within 50% to 150% of the mean.

ScenarioShiller PE after 8 YearsAnnual Return from Today (%)
Really LuckyMean x 150%6.9%
LuckyMean x 125%4.6%
Reverse to the MeanMean x 100%1.8%
UnluckyMean x 75%-1.7%
Really UnluckyMean x 50%-6.3%

Investment Strategies at Different Market Levels

The Shiller PE and the ratio of total market cap over GDP can serve as good guidance for investors in deciding their investment strategies at different market valuations. Historical market returns prove that when the market is fair or overvalued, it pays to be defensive. Companies with high quality business and strong balance sheet will provide better returns in this environment. When the market is cheap, beaten down companies with strong balance sheets can provide outsized returns.

To summarize:

  1. When the market is fair valued or overvalued, buy high-quality companies such as those in the Buffett-Munger Screener.
  2. When the market is undervalued, buy low-risk beaten-down companies like those in the Ben Graham Net-Net Screener. Buy a basket of them and be diversified.
  3. If market is way over valued, stay in cash. You may consider hedging or short.

Again, here you can see the Sector Shiller PE, it shows you which sectors are the cheapest. Here you can see Shiller PE of individual stocks.

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