The purpose of Shiller PE 10 is to provide long term risk to reward analysis based on earnings and current prices.
Shiller PE 10: Advantages, Criticisms, and Implementation
Used properly, PE 10 will help guide you to asset allocation decisions that improve long term returns and lower your risk of large portfolio drawdowns.
Professor Robert Shiller of Yale University developed the Shiller PE 10 to more accurately reflect long term trends and smooth volatile components of the standard P/E ratio. PE 10 is also called the Cyclically-Adjusted P/E ratio (CAPE). The “10” represents the rolling 10 year periods Shiller uses to calculate PE 10.
The PE 10 for the S&P500 is the price of the index divided by 10 year inflation adjusted average earnings. The calculation is: S&P 500 annual earnings for the each of the past 10 years adjusted each year for inflation (using the CPI); then calculate the average for the decade. This number is then divided into the price of the S&P 500 to get the current Shiller PE 10.
The higher the PE 10 the more overvalued the market is historically. The lower the PE 10 the more undervalued the market is historically. You can find PE 10 at Multpl.com with a ton of great information and charts.
Advantages of Shiller PE 10
Profit margins and earnings are cyclical in nature; therefore the standard and widely popular P/E ratio can be quite volatile. The earnings for any one year may not reflect true earnings because they are affected by expanding and contracting business cycles. For example in the first quarter of 2009, because of a short term collapse in earnings, the standard P/E ratio was over 100 when the market was clearly undervalued and near a bottom.
Shiller uses rolling ten year periods to average or smooth earnings. The PE 10 provides a better representation of long term earnings trends by showing a version of the P/E that is smoothed out over a number of years.
Shiller was able to show that the P/E 10 at any given time was correlated to what market returns would be over the next 20 years. In simplified terms, if PE 10 is high the expected rate of return for the next 20 years is lower than average. But when the PE 10 is low the expected rate of return for the next 20 years is higher than average.
In my opinion, the research into valuation based strategies is strong. Valuation investing improves risk adjusted returns compared to strategic or fixed asset allocations.
Criticisms of Shiller PE 10
There are criticisms of PE 10, most of which I believe is unjustified. Some investors believe that the market is efficient and would not provide extraordinary returns to someone just because they invest in the market when valuations are low. But historical evidence proves them wrong.