The stock market is commonly referred to as the battle between bears and bulls, where volatile price changes create opportunities for investors. Due to the opportunities that lie between the ebbs and flows of the market, investors and traders alike use various tools to determine whether valuations are low, high, or fair in the search of the next profitable investment.
One such tool is known as the Shiller P/E ratio.
Developed by Professor Robert Shiller, a Nobel Prize-winning economist who teaches at Yale University, and author of the bestselling book “Irrational Exuberance,” the ratio was designed to even out the short-term fluctuations seen in the traditional measurement of price-to-earnings ratio and provide a more realistic view of the market as a whole.
What Is the Shiller P/E Ratio?
The Shiller P/E ratio, also known as the cyclically adjusted price-to-earnings (CAPE) ratio, was designed to remove the noise of volatility in earnings readings by looking at the data over the course of 10 years.
The ratio was introduced when Shiller and his colleague John Campbell presented research to the U.S. Federal Reserve in December 1996, suggesting that prices in the stock market were growing far faster than corporate earnings, and ringing a warning bell that a market crash could be just around the corner. The ratio gained more awareness when the team published an article titled “Valuation Ratios and the Long-Term Stock Market Outlook.”
At the time, the team used the valuation metric to determine that the market was destined for a 40% decline from current levels. Although the market seemed to ignore the stern warnings, it eventually crashed in 2001 after high valuations in the tech industry led to a bubble that popped, resulting in a more than 70% decline in the tech-heavy Nasdaq index.
How was the team able to predict such a crash so early?
The CAPE ratio looks at the real earnings generated by companies over the past 10 years, creating an average earnings per share (EPS). That average EPS is then compared to the company’s stock price to determine whether the stock is over or undervalued.
Shiller and Campbell used this metric to determine the state of the S&P 500 index as a whole, comparing current price to average inflation-adjusted earnings and generating alarming results. The valuation measure suggested historic overvaluation — a sign that pointed to grim times ahead.
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How Is the CAPE Ratio Used?
Many investors, traders, and economists use the ratio when forecasting market conditions. Not only is the ratio used to determine the state of the market as a whole, but it can also be used to determine the state of an individual asset like a stock or ETF. Here are a few examples:
Applied to Individual Assets
When using the ratio for individual assets, an investor, trader, or economist compares the average inflation-adjusted earnings per share of the asset over the past 10 years to its current price.
For example, if ABC Company generated $5 per share annually on average over the past 10 years and currently trades with a price of $200 per share, you would determine the CAPE ratio by dividing $200 by $5, giving you a value of 40.
If you’re looking at a tech stock, that ratio would suggest the stock is undervalued considering the average ratio among tech stocks is currently about 47, according to Gurufocus. On the other hand, if ABC Company is a financial company, the ratio would suggest a significant overvaluation compared to the average financial stock ratio of 22.5.
As a Total Market Metric
While the ratio can be used on an individual-investment basis, it is most commonly used to determine the state of the market as a whole. To do so, the prices per share of all companies listed on the S&P 500 index, or other market benchmark, are combined and divided by the total amount of annual earnings generated by these companies averaged out over the past 10 years.
For example, let’s say the average EPS across the index over the past 10 years was $114 with the price of a share of the index sitting at $4,352. Dividing $4,352 by $114 would give you a ratio of just over 38, which is a cause for concern.
History suggests that when the market is healthy, the Shiller P/E ratio sits between 16 and 20. When the total market ratio has climbed over 25 for a prolonged period of time, it has been a red flag that a crash is coming, and the magnitude of that crash has been larger as the number got higher.
As a result, when the Shiller P/E ratio veers too high above a reading of 25, many investors take precautions, moving assets to safe havens. Conversely, many investors begin significant buying of growth assets any time the ratio drifts below 16.
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What Is the Significance of 10 Years of Data?
The primary driver of the ratio’s stability is the fact that it measures the data over the course of a 10-year moving average, rather than measuring real earnings for this year in comparison to the current price.
Although Shiller turned the data into an easy-to-use metric, the first time this theory was suggested was by Benjamin Graham — the father of value investing — and David Dodd, co-authors of “Security Analysis.” In the book, the team suggested that it’s best to average earnings over the course of seven to 10 years when determining the fair value of stocks.
Why is that 10-year mark so important?
Almost all companies go through several business cycles as they grow and evolve. In each of these cycles, they may achieve different levels of earnings. By valuing a company based only on its current business cycle, investors may be missing important data about what could happen in the future.
Moreover, the economy has cycles of its own, which also affect earnings. By looking at today’s raw data, your view may be skewed by the positive impact of economic expansion or the negative impact of economic contraction, depending on whether the economy is ebbing or flowing at the time.
As a result of the cyclical nature of businesses themselves and the economy, ratios like price-to-earnings and other valuation metrics can fluctuate significantly from one year to another.
Drowning out the noise by averaging the data over a decade gives a clearer picture of whether an asset or market is under- or overvalued, regardless of the state of the economy or the current business cycle. What matters in this metric is historic data and current market price, the two stats that many believe offer the clearest picture of value.
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Historic and Current Readings
Although there has been plenty of debate surrounding the efficacy of the Shiller P/E ratio in predicting market crashes, the metric does appear to have flashes of warning signs before several market crashes throughout history. For example:
- The Great Depression. In November of 1929, the Shiller ratio had a reading of 33.1 just before the market crash that resulted in the Great Depression.
- The Great Recession. In October of 2007, just before the Great Recession, the ratio was 25.7.
- Dot-Com Bubble Burst. In 1999, just before the dot-com bubble popped, the ratio had a reading of 44.2.
As of July 2021, the ratio currently sits at 38.21.
Considering the significant declines that have happened in the past when the ratio reached a reading of over 25, it suggests that a market crash may be on the horizon. However, many experts argue against the notion that a crash is coming, stating that the ratio is a backward-facing metric that doesn’t take forward-looking growth into the equation.
Although there are plenty of people who argue against the Shiller P/E ratio as a predictor of future market movements, there’s no arguing the fact that its readings were significantly high prior to most major market crashes throughout recent history.
Moreover, by paying attention to the ratio on an individual investment basis, you’ll get a better picture of the value you’re buying into when you buy new shares. All in all, using the ratio as part of your research sets the stage for a better understanding of the value you’re getting when you make an investment.