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The Shiller P/E and Economic Conditions

  • ,  Chief Executive |
  • 07 Sep 2018
  • Updated 26 Apr 2019

The Cyclically Adjusted Price-to-Earnings Ratio (CAPE)

The Shiller P/E ratio, or cyclically adjusted PE ratio (CAPE) is an equity valuation measure where the denominator is based on inflation-adjusted earnings, smoothed over the last 5-10 years. In theory, investors expect this measure to revert to the mean over the long-term, but history shows us that P/E can remain elevated or suppressed for extended periods.

What are the drivers of the level of Shiller's CAPE? To what extent does this depend upon macroeconomic conditions, demographic change, or other secular factors? The papers below consider a variety of compelling arguments and counter-arguments, which seek to unlock a better understanding of the long-term direction of global equity markets.

CAPE ratio Shiller PE

The Shiller P/E and Macroeconomic Conditions (The Journal of Portfolio Management, 2018)
In this paper for the Journal of Portfolio Management, Robert D. Arnott, Denis B. Chaves, and Tzee-man Chow examine the interplay that exists between the Shiller P/E ratio and the macroeconomy.

Demographics, Inflation and Asset Prices (Goldman Sachs AM, 2018)
The authors of this report describe the ways in which demographics and inflation relate to asset prices, presenting their own demography-based predictions for major economies.

A cracked rear-view mirror: Shiller P/E ratios and equity market valuations (BNP Paribas AM blog, May 2018)
Daniel Morris of BNP Paribas Asset Management states in this blog post that the main benefit of the Shiller P/E is that the long-term data set behind it goes back over 100 years, whereas its weaknesses are numerous. 

CAPE Fear: Why CAPE Naysayers Are Wrong (Research Affiliates, 2018)
The U.S. CAPE ratio is at historically high levels, but should these valuation multiples alone instigate fear, or should we fear the ratio itself due to its inability to predict market highs and lows?

The Coming Bear Market (Robert Shiller, Sept 2017)
The US stock market today looks a lot like it did at the peak before all 13 previous price collapses. That doesn't mean that a bear market is imminent, but it does amount to a stark warning against complacency.

Equity Valuation: Science, Art, or Craft? (CFA Institute Research Foundation, 2017)
How do active investment managers form nonconsensus beliefs?  The authors interview PMs, analysts, CIOs, and directors of research at firms within Europe and North America. 

A Silver Lining - Investment Implications of an Aging World (PGIM, 2017)
(For compliance reasons, this paper is only accessible in the United States)
The global population is getting older, and demographic megatrends such as this create new opportunities in senior housing, condominiums, biotech, and the silvertech industry.

The Shiller CAPE Ratio: A New Look (Financial Analysts Journal, 2016)
This research paper from Jeremy Siegel was originally published in the CFA Institute's Financial Analysts Journal, and describes how recent equity forecasts may be overly pessimistic due to changes in earnings calculations. 

Market Timing - Sin a Little: Resolving the Valuation Timing Puzzle (Cliff Asness, JoIM, 2017)
The authors look at whether market timing adds value or should be avoided altogether, leading to the suggestion of adding momentum to value timing strategies. 

Equity Market Valuation: Multiple choice (UBS, Sept 2017)
The price to earnings ratio is used by investors as a core measure of equity market value. But do investors place greater weight on it than it deserves? UBS looks at the predictive power of the PE ratio for forward index returns.

What Does Population Aging Mean for Growth and Investments? (KKR, Feb 2018)
What does population aging mean for investment, growth, and social cohesion globally?  KKR addresses some of these implications, along with the investment opportunities that arise as a result.

Equity Risk Premiums: Determinants, Estimation, Implications (Damodaran, 2018)
Professor Aswath Damodaran examines ways of estimating the ERP. He begins by considering economic determinants, including information uncertainty, perceptions of macroeconomic risk and risk aversion by investors.

Demographics will reverse three multi-decade global trends (BIS, 2017)
With aging global populations, will come higher real interest rates, inflation, and wage growth, along with less inequality, thereby reversing trends that have been effect for several decades. 

Structural Trends in Equity Market Valuation (Absolute Return Partners, 2015)
This April 2015 document from Absolute Return Partners looks at the structural factors that drive equity prices, including Corporate Profits as a share of GDP, dividends and share buy-backs, demographics, interest rates and valuations.


Further commentary on the Shiller P/E ratio

The Shiller P/E Ratio is one of the most respected measures of equity market valuation, and is often used by asset allocators as a guide to value. Allocators and strategists will often "underweght" those assets which they deem to be overvalued, and "underweight" those assets which they deem to be undervalued. One of the key advantages of using the Shiller PE is that it is cyclically adjusted. Therefore, this measure is less likely to describe equities as "cheap" at the top of an economic cycle (when corporate earnings are high) and "dear" at the bottom of the cycle (when earnings are low).

One possible argument against using the Shiller P/E Ratio is that it takes no account of the current level of interest rates (or bond yields). In the 1970s to 1990s there was a reasonably strong correlation between the level of bond yields and the earnings yield (the inverse of the PE ratio). As a result of this, many asset allocators in the 1990s would take into account the level of bond yields when assessing the valuation of equity markets. This was perhaps best encapsulated in the so-called "Fed Model" which in its strongest form assumed an equilibrium between the one year forward-looking earnings yield and the yield on US 10 year government bonds. This measure was particularly in vogue in the 1990s, but went out of fashion in the 2000s as the relationship broke down. One of the criticisms of the Fed Model is that it lacks any justifiable theoretical underpinning. The dividend yield (and by extension the earnings yield) is related to the "real return" on equities, while the bond yield is a measure of "nominal return".

Therefore, for long-term measures of equity market valuation, the Shiller P/E ratio is considered by many asset allocators to be the valuation measure with the greatest credibility.