What is the Shiller P/E Ratio?

Is now a good time to invest in stocks?  This is one of the most frequently asked questions I get from potential clients.  I like it because then I can whip out my crystal ball, put on a turban and John Lennon glasses, and lower my voice to mysteriously claim "... I see the S&P 500 3 years from now at ...."  Seriously, though, there is a tool that DIYers should know about that is widely used for valuation purposes; and that is the Shiller P/E.

Bob Shiller, author of Irrational Exuberance, is credited with foreseeing the dot.com bust as well as the housing crisis.  He has been named one of the country's top 100 most influential economists.  He is one of the leading voices in the argument that markets are not efficient and uses his particular P/E construction in that argument.

We've looked at the P/E ratio as an important valuation metric before and have noted that there are various measures, including 12-month trailing earnings and expected earnings.  The Shiller P/E is based on the past 10 years earnings adjusted for inflation.  Here is a visual from gurufocus:

Notice in the graph where Shiller's P/E was prior to the dot.com crash in 2000 and the housing market crash of 2008.  In both instances, it was well above its historical mean - hence, its reputation as a valuation metric.

Today, as you can see, the Shiller P/E is 25% higher than the historical mean.  This would suggest that better opportunities for entering the market may be ahead.  Asset allocators may choose to use this tool to go to the lower bands in their targeted allocations.  Investors looking to enter the market may decide to average in, thereby expecting better entry points.

It is important to understand that this methodology assumes an inefficient market and that this inefficiency tends to dissipate over time - i.e., reversion to the mean takes place.

My assessment is that the tool is valuable at the extremes.  If it moves outside the 25% band from here,  asset allocators may in fact want to get a bit defensive and increase that defensiveness as the ratio moves further from its historical mean.  As a valuation measure, I believe it is one of the best around and would encourage anyone interested in assessing the market from a longer-term perspective to study and track this metric.  Furthermore, if you haven't read Irrational Exuberance, get a copy and read it - you'll be smarter because you did.

There is another use for Shiller's P/E that we'll take up in the future - as a guide for the safe withdrawal rate for retirees.  As always, this information is for educational purposes only.  Individuals should do their own research or consult a professional before making investment decisions.

High-IQ Investors

I have to say that, in my experience, some of the smartest people I have ever met have been the lousiest investors.  In fact, the only thing that has saved them has been their high incomes.  They anaylze individual stocks and find it hard to believe that what they have learned the market already knows and is reflected in the price of the stocks, are absolutely adamant about the direction of the market, and tend to chase the hottest performing sectors, and get caught up in bubbles because bubbles tend to reinforce their belief in their own genius.  But my data set isn't that large, so I'll defer to a fascinating study by Mark Grinblatt of the University of California, Los Angeles, Matti Keloharju of Aalto University in Helsinki and Juhani Linnainmaa of  the University of Chicago, What High-IQ Investors Do Differently, described by Robert Shiller.

The study is based on data from Finland where young men are required to serve in the military and, thereby, are given IQ tests.  Finland also has a wealth tax which requires investment portfolios to be  reported.  According to Shiller, the researchers find that the propensity to follow accepted portfolio techniques--diversify, invest in low cap stocks, etc.--is greater for higher IQ men (it seems that females may have been skipped in this study!).  Interestingly, nothing is reported, as far as I can tell, on performance, which of course would be the bottom line!

Shiller goes on to say that the bigger issue might not be intelligence per se but a lack of trust.  The ability to learn who to trust though, according to Shiller, is dependent on intelligence.  He cites a second study that found those with a "high level of trust" were more likely to invest in the stock market.  To me, this is a sort of "duh!" finding.

I am a huge fan of Shiller and have admired his books and especially the research he has done on the p/e ratio.  I believe it is useful for determining entry points for long-term investing.  Still, I have some difficulty with statements he makes. For example, he says

 Successful investing requires that we judge other people, and it relies on an ability to develop a good model of others’ minds.

Frankly,  I'm not even sure what the last part of the sentence means.  My main beef, though, is that just investing in the market with a well-diversified portfolio comprised of low-cost funds has been very successful over the long run.  In fact, voluminous evidence supports the finding that it outperforms 70% to 80% of all professionals after all costs are accounted for!  There is no need to "...judge other people."  More than anything, it requires a belief that the economic system will continue to produce remarkable products.  In a world where the information available to geniuses with a laptop is proliferating at an amazing rate, I believe it is a belief that is easy to accept.

I  would like to see a study on how much wealth has been lost because people went to Mr. High IQ for investment advice!

Shiller vs. Siegel

Robert Shiller of Yale (author of the well-timed Irrational Exuberance) and Jeremy Siegel of Wharton (author of the prescient Stocks for the Long Run) continue to disagree on the future course of the market. If you follow Shiller, you believe that stocks are at or close to being overvalued. Siegel's view is that stocks offer value at today's prices and now is a time to be bullish.

DIY Investor believes that the appropriate stance is to focus on developing a strong asset allocation plan and sticking with the plan. Still, the views of these two giants in the investment world are worth listening to: