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The Shiller CAPE Ratio

February 6, 2013 - 7 comments

Most stock market forecasters have terrible track records (although they continue to make their predictions, with little to no accountability).  However, one metric has been shown to offer some degree of predictive ability; the Shiller CAPE ratio.

The Shiller “cyclically adjusted price-to-earnings” ratio   takes the current price of the stock market and divides it by the average stock market earnings over the past 10 years (adjusted for inflation).  By averaging the earnings over 10 years, the effects of large earnings fluctuations in any given year are mitigated.  A high relative value indicates an overpriced stock market, while a low figure indicates a bargain.

Vanguard recently produced a paper titled, Forecasting stock returns: What signals matter, and what do they say now?  They found that valuation measures, such as the Shiller CAPE ratio, have shown some modest historical ability to forecast long-run returns.  So what are these valuation metrics saying today?

The CAPE Crusader 

Luckily for us, Raymond Kerzerho, Director of Research at PWL Capital, has come to the rescue.  He has constructed Shiller CAPE ratios for some well-known stock market indices:

The Earnings Yield (E/P)

In order to estimate the real expected long-run return of the stock market, you will need to take the inverse of the Shiller CAPE ratio; this will give you the amount of real earnings you should expect for each dollar you invest.  I also prefer to adjust this figure downwards by about 1% to account for earnings dilution (i.e. some of the earnings will go to owners and shareholders that do not yet exist).

Future Expected Portfolio Returns

If we assume inflation of 2% going forward, and nominal bond returns of 2.25%, what would be a reasonable return expectation for various Couch Potato asset allocations going forward?

Although these future returns could be better or worse than expected, this framework can be used to construct appropriate asset allocations that would be expected to meet the investor’s individual financial goals (stay tuned for my next post on this topic).  As always, investors should never increase the risk of their portfolio beyond their ability, willingness and need to take risk.

By: Justin Bender with 7 comments.
Comments
  02/06/2014 9:51:54 AM
Justin Bender
@Grant - the inverse of the current Shiller CAPE would give an expected real "earnings yield" for stocks (similar to a real bond yield). Swedroe was pointing out that the method is not perfect - there can be a fairly wide range of outcomes (both better or worse than expected).
 
  01/06/2014 7:25:39 PM
Grant
In Larry Swedroe's new book "Reducing the risk of black swans" he says that when the Schiller CAPE is 25, as it is now (for the S&P 500 index), the long term real returns average is 1% (with a wide range if -4.4 to 8.8). In your article, inverting 25, gives a figure of 4%. Is this a mean figure, or am I missing something here? Thanks.
 
  13/10/2013 5:33:42 PM
Rex
re #227 3b To re-inflate the securitzation bulbbe the Bankers would need investors to buy whatever new form of ABS they can come up with. If you remember Paulson early on during the crisis was taking about European covered bonds. The securtization community is now coming up with a new plan called Project Restart and they had their conference two weeks ago in Vegas. Sandra Thompson, director of the division of supervision and consumer protection at the Federal Deposit Insurance Corp gave the keynote speech and talked about aligning incentives, simplifying pooling structures, improving credit analysis and strengthening servicing arrangements.They (gov and banks) firmly believe they can re-inflate the securitzation bulbbe, and you can bet Obama does too. U.S. banks are now looking to follow Washington Mutual's example to issue covered bonds here in the USA. European issuers are now testing placing covered bond issues in the U.S. With credit spreads continuing to tighten more investors are looking for alternatives.The only real money to be found today that our Government could control is to be found in Pension funds both public and private. The legislation is already in the pipeline to force this issue, that you can be sure of.
 
  21/02/2013 5:43:53 PM
Justin Bender
@Andrew F - you are correct - the earnings yield I posted is in real terms.
 
  21/02/2013 3:55:52 PM
Andrew F
Justin,

Since the earnings in CAPE are inflation adjusted, would not the earnings yield also be in real terms?
 
  12/02/2013 5:21:22 PM
Justin Bender
@Jamie - the expected portfolio returns in the last table shown above are nominal (meaning that they would be before inflation) - the real expected return (after inflation) for a 50:50 mix in this example would be 2.5%.
 
  12/02/2013 1:56:24 PM
Jamie
You mention 'assume inflation of 2%', does this mean the estimated reruns are after inflation (4.5% for 50:50 mix, not 2.5%)?
Thanks
 



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