What is the Shiller PE?
The Shiller PE is a valuation indicator for an equity index. It has a reliable track record in determining if the stock market is cheap (PE = 10) or expensive (PE = 25).
It works best on long term horizons of 10 years or so.
Why would it work?
The stock market consists out of different types of companies, that all follow their own cycle: some companies do well at the start of a business cycle (early cycle), others do well at the end (late cycle). Some companies respond strongly to the business cycle (cyclical companies), others don't (defensive companies). Averaging earnings cancels out the impact of that cycle for those companies.
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Did you know that cyclical companies get more expensive (a higher PE) in recession?
=> This is because of the Molodovsky effect.
The Molodovsky desribes that earnings of cyclical companies decline in recessions and therefore its PE increases. So the valuation increases in recessions. Defensive companies experience this in a much lesser extend.
Adjusted R2 versus forecasting horizon for variables with longest available history, Q3 1930 – Q2 2017
Source: Barclays
Explanation
This graph shows the R2 for different forecasting horizons. A higher R2 means that there is a better fit with future returns. In short: it has better forecasting power. The graphs shows that this forecasting power increases with the horizon. So the longer the horizon, the better its forecasting power. It also shows that the CAPE stands out on almost all horizons. But be careful: the Shiller PE can help you form an expectation about the future. It is never an exact science.
So: if you are a patient long term investor, the CAPE can be a very useful tool for you.
Source: Barclays
Statistical analysis shows Shiller's predictive value increases with time horizon.
The Challenge
Since 1995, the Shiller PE seems to have experienced a permanent higher plateau. The average of the PE before 1995 was 14. Since 1995 until now the average has been 28. If this is indeed the case, why would it be? And how does it impact the use of the ratio in asset allocation analysis.
If is not a structural higher plateau, what could explain this?
Read on for answers
Source: Shiller
Cyclically Adjusted PE
Use historic average earnings to calculate the valuation, instead just current earnings. Also know under it's abberviation: CAPE
DIFFERENT NAMES
SIMILAR CONCEPT
Graham & Dodd PE
Exactly the same as the cyclically adjusted PE, but initially aimed at individual companies and 'invented' in 1934
Shiller PE
Robert Shiller used real values to calculate the PE, instead of nominal values. So he corrects both earnings and the stock price index for inflation.