The goal of this post is to explain the basics of Shiller PE 10 and how to use this valuable stock market valuation tool. 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.
What is Shiller PE10?
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 price-to-earnings (CAPE) ratio. 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 PE10
Profit margins and earnings are cyclical in nature; therefore the standard 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.
For those of you would like to do further research another great resource is Rob Bennett’s site Passion Saving.
Criticisms of Shiller PE10
There is much criticism 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”. I believe these critics take PE 10 too seriously. There are no set rules for buying or selling. But the general valuation of the market, as presented by PE 10, gives the analyst valuable information.
Implementing PE10 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 PE10 into my portfolio asset allocation model:
When PE 10 is Low:
When PE10 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. So I am more apt to broadly diversify my portfolio by having a higher percentage of assets in ETFs or low cost index funds.
Summary: The lower the PE10 the higher percentage I allocate to equites. I increase broad diversification through market index funds and ETFs.
When PE10 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 equites.
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 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. I decrease broad diversification and concentrate more on individual stocks that offer a high margin of safety.
Stock Market Valuation and PE10
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 management. PE 10 will help guide you to asset allocation decisions that improve long term returns and lower your risk of large portfolio drawdowns.
Related Reading: Market Timing vs. Valuation Timing