Shiller P/E Ratio: Current Stock Market vs. Historical Average

 

What Is the Shiller P/E Ratio?

Robert Shiller, born in 1946, is an economics professor at Yale University. You might have heard the term "Case-Shiller Index" at some point. It's one of the most commonly used indicators to track trends in the U.S. housing market, and it’s published by S&P. Professor Shiller predicted the collapse of the real estate market and the ensuing financial crisis from 2005, well before it occurred in 2008. He also won the Nobel Prize in Economics in 2013.

There’s a metric called the CAPE ratio created by Professor Shiller, also known as the Shiller P/E ratio. CAPE stands for "Cyclically Adjusted Price-Earnings." It’s typically used to evaluate the long-term value of an entire stock market or a specific index, rather than individual companies. It is calculated by dividing the current price index by the inflation-adjusted average earnings per share (EPS) over the past 10 years of the companies that make up the index. The most widely used version is the "S&P 500 Shiller P/E ratio" applied to the S&P 500.

The Shiller P/E ratio is usually used to gain insight into whether the market is overvalued or undervalued. Unlike the regular P/E ratio, which is heavily influenced by short-term earnings fluctuations, the Shiller P/E removes short-term market noise and reflects long-term earnings trends, making it useful for assessing market value. It helps gauge how the market is moving compared to past averages, and if the current Shiller P/E is much higher than historical averages, a bubble might be suspected. For instance, the ratio reached unusually high levels before the Great Depression in 1929 and the Dot-com bubble in the 2000s.

Current Level of S&P 500 Shiller P/E Ratio

So, what is the current level of the S&P 500 Shiller P/E ratio, and how does it compare to historical levels?

Source: www.gurufocus.com

As of September 1, 2024, it stands at 35.8. One of the great advantages of the Shiller P/E ratio is that you can review very long-term data. The chart starts from 1871, allowing a comparison of over 150 years of index changes. Three large peaks immediately stand out:

• 31.5 just before the Great Depression of 1929
• 44.2 during the Dot-com bubble in 1999
• 38.6 during the Covid-19 bubble in 2021

The current Shiller P/E ratio is much lower than it was during the Dot-com bubble but exceeds the level before the Great Depression and is similar to that of the Covid-19 bubble. Many stock experts argue that the impact of AI, which took off in earnest at the end of 2022, will be much greater than the impact of the internet in the late 1990s, and investor mania will repeat itself. When looking at this, you might think that’s possible - assuming the U.S. economy continues expanding without a recession, just as it did in the late 1990s.

How Rare Is a 35.8 CAPE Ratio?

Looking at the chart, you’ll notice a light blue-shaded area in the middle. This area shows where the Shiller PE ratio falls within +/- 1 sigma (standard deviation). Assuming the index follows a normal distribution, +/- 1 sigma covers about 68% of the distribution. Calculating the probability that the index is above +1 sigma gives (50% - 68%/2) = 16%. It’s not common, but it’s not a rare occurrence either. So, what about +/- 2 sigma? 2 sigma covers about 95% of the distribution. Although it’s not shown in the chart, based on my rough calculations, the range for the Shiller P/E ratio is approx. 2.4 to 31.6. The current index of 35.8 exceeds +2 sigma. The probability of this happening is less than 2.5%.

We might calculate the exact probability of the Shiller PE ratio rising to 35.8, but it seems rather meaningless. Earlier, I mentioned that the lower bound of 2 sigma is approx. 2.4, but when the Shiller P/E hit its all-time low in the 1920s, it was about 4.8. The -2 sigma level of 2.4 has never been reached, whereas the +2 sigma level of 31.6 has been exceeded several times. In other words, stock indices don't seem to follow a normal distribution (although with hundreds of years of additional future data, it could eventually be confirmed to follow a normal distribution, but that seems highly unlikely). This is why I said rigorous calculations based on the normal distribution assumption seem rather meaningless.

Drawbacks of the Shiller P/E Ratio

Like the Buffett indicator, the Shiller P/E ratio also has its drawbacks. Because it uses a 10-year average of earnings, it doesn’t fully reflect recent earnings. If the economy, industry structure, or emerging technologies have undergone significant changes over the past decade, altering the growth potential or future earnings outlook of listed companies, historical data may become less relevant.

If the economy or industry structure has significantly shifted in the past decade, or if new technologies have emerged that greatly impact the growth potential and future earnings outlook of listed companies, the Shiller P/E ratio may be slow to account for these changes. As a result, comparisons with historical data may become less relevant.

As you know, we are living in an era where AI is changing the world. As AI advances, it is expected to reshape the economic structure, industry composition, overall productivity, growth rates, and national competitiveness, among other factors. So, should we ignore the Shiller P/E ratio of 35.8, which seems uncomfortably high? According to John Templeton, the four most dangerous words in investing are "This time, it’s different."

Thanks for reading. I wish you success in making smart investments!

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