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.
Value Sign
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.
Related: The Three Best Performing Long Bonds of Last Month
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.
Another criticism is that it is a long term indicator and does not provide enough buy and sell “signals”. This is more evidence that too many investors are focused on short term results and too impatient to think long term.
In addition I believe these critics take PE 10 too seriously. There are no set rules for buying or selling. There are no “magic formulas” that give exact answers. However the general valuation of the market, as presented by PE 10, gives the analyst a frame of reference to judge the balance between risk and reward.
Implementing PE 10 In Your Portfolio Asset Allocation
I don’t use any iron clad rules. This isn’t a scientific formula that makes your research and homework go away. This is how I implement PE 10 into my portfolio asset allocation:
When PE 10 is Low:
When PE 10 is low I know the odds of higher than average long term returns are in my favor. So I increase my asset allocation to equities.
I also know the odds are better for the entire market when PE 10 is low. Therefore I might be apt to broadly diversify my portfolio by having a higher percentage of assets in ETFs or low cost index funds.
Summary: The lower the PE 10 the higher percentage I allocate to equities. Broad diversification through market index funds and ETFs is acceptable.
Related: Highest Conviction Fixed Income Trade
When PE 10 is High:
When PE 10 is high I know the odds of lower than average long term returns are what to expect. So I decrease my asset allocation to equities.
I also know, because of higher risk, I need a higher margin of safety in the investments I choose. This means I will place a higher percentage (maybe even 100%) of my equity allocation in individual stocks, instead of index funds or ETFs. This allows me to tightly control my risk and only invest in individual companies that meet my margin of safety requirements.
Summary: The higher the PE 10 the lower percentage I allocate to equities. Broad diversification is less desirable and concentrating on individual stocks that offer a high margin of safety is preferred.
Stock Market Valuation and PE 10
The Shiller PE 10 is not a magic formula to make your asset allocation decisions for you. It is a valuable stock market valuation tool for risk/reward management. PE 10 will help guide you to asset allocation decisions that improve long term returns and lower your risk of large portfolio drawdowns.