Sources
The roots of Shiller PE go back to 1934
The indicator was introduced by Mr Graham and Mr Dodd, teachers of Warren Buffet, and was mentioned in their classic work “Security Analysis“. The book everyone talks about, but nobody has read.
Why is context or history important? It learns about the past. History never repeats itself, but it rhymes.
“Those who cannot remember the past are condemned to repeat it.”
– George Santayana. A Spanish writer who lived in the US for a long time.
A brief history
Popularized by Robert Shiller…
The Cyclically Adjusted Price Earnings ratio (CAPE), also known as the PE10-ratio or the Shiller index, was popularized by Professor Robert J. Shiller, an Economist from Yale University, when he published his book: “Irrational Exuberance”.
… but Graham and Dodd came up with it first in 1934
Robert Shiller was inspired by the book Security Analysis in which Benjamin Graham and David Dodd suggested to use an earnings average to determine a fair valuation for individual stocks: “not less than five years, preferably seven or ten years.” For this reason some analysts still refer to the index as the “Graham & Dodd PE ratio”.
Robert Shiller applied it to equity indexes and delivered proof
Robert Shiller conducted research, with John Campbell in 1996 on valuation ratios for equity indexes. They collected and analysed S&P 500 Index data from 1871 to the current day to determine if this amended PE-ratio would be effective and more accurate in determining if the market as a whole was overvalued or undervalued. And it was. They observed: when markets are overvalued, two things can happen:
- equity prices fall to bring valuation in line with long term history or
- earnings grow enough to bring valuation in line with long term history
They found that it is always equity prices that fall when the ratio is high.
What he found was that in general a Shiller P/E Ratio of roughly 18-20 meant that the market was properly priced as measured against earnings averaged over the previous ten years. Dr. Shiller’s data set can be found here.
Yes! Even if you are a long term investor, it matters when and how much you invest.
But.. Siegel’s critique
Jeremy Siegel however has critized the work of Robert Shiller in August 2013 during a CNBC interview. Shiller uses the S&P earnings, which are – according to Siegel – biased. Siegel thinks you should use earnings of all companies in the US, the NIPA. But NIPA has some important flaws as well.
Check out an excellent summary of the two viewpoints on the website of Advisor Perspectives.
In 2011, some suggestions were made.
But in 2011 this article [TO BE ADDED], came up with an explanation of why the CAPE has been higher.
Vanguard ranks Shiller PE as best predictor
A much quoted article, from 2014, done by Vanguard shows that the CAPE performs better than other valuation measures.
Finally some clarity? Shiller driven by inflation in interest rates.
In 2018, a paper from Rob Arnott is published. Research Affiliates has found a statistical explanation for the elevation since 1995: interest rates and inflation. It is both the level and volatility of those factors that can explain the deviation. And it makes sense: if economic growth is more stable and inflation is reliable and low, an investor runs less risk, so the valuation goes up.
Check it out here: King of the Mountain: The Shiller P/E and Macroeconomic Conditions | Research Affiliates