What is the Shiller P/E?
The Shiller P/E ratio, also known as the cyclically adjusted price-to-earnings (CAPE) ratio, is a popular valuation measure used by investors to assess the overall market valuation and the potential for stock market returns over the long term. Created by Nobel Prize-winning economist Robert Shiller, this ratio has gained significant attention for its ability to provide insights into market overvaluations or undervaluations.
“The higher the Shiller P/E ratio, the more overvalued a market. For context, over more than 100 years, the average and median Shiller P/E ratio has been around 15 or 16, spiking up significantly higher before market crashes. ”
What is the Shiller P/E Ratio?
The Shiller P/E ratio is calculated by taking the current price of a stock index, such as the S&P 500, and dividing it by the average of ten years of inflation-adjusted earnings.
This is in contrast to the traditional P/E ratio, which uses only one year of earnings. The use of a ten-year average helps to smooth out the impact of economic cycles and gives a more comprehensive view of stock market valuations.
Benefits of the Shiller P/E Ratio
One of the key benefits of the Shiller P/E ratio is its ability to provide a long-term perspective on market valuations. By considering earnings over a ten-year period, it helps to mitigate the impact of short-term fluctuations in earnings or market prices. This can be particularly valuable for investors who are focused on long-term strategies and want to understand whether the market is priced at a level that is likely to deliver satisfactory returns over the coming years.
Moreover, the Shiller P/E ratio can act as a useful tool in identifying market bubbles or periods of excessive optimism. High Shiller P/E ratios may indicate that the market is overvalued, potentially leading to lower future returns, while low ratios could signal undervaluation and the potential for higher future returns.
Limitations of the Shiller P/E Ratio
While the Shiller P/E ratio is a valuable tool, it does have limitations. Critics argue that using a ten-year average of earnings may not always be reflective of current market conditions, especially during periods of significant economic upheaval or technological disruption. Additionally, the ratio should not be used in isolation but rather as a part of a comprehensive analysis that considers other fundamental and macroeconomic factors.
Current Shiller P/E
As of this writing, the Shiller P/E is 36.81. Compare that to the historical average of 15 and you see a current market that is significantly overvalued.
Conclusion
In the realm of stock market valuation metrics, the Shiller P/E ratio stands out as an important indicator for investors seeking a long-term perspective on market valuations. While it has its limitations, its ability to smooth out the impact of short-term fluctuations in earnings and market prices provides valuable insights for investors. By understanding and utilizing the Shiller P/E ratio, investors can make more informed decisions and potentially enhance their long-term investment outcomes.
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