Why it works

What works and why?

The Shiller PE is a great indicator to tell you whether the market is cheap or expensive. The best bang for your buck you get at discounted prices. So when valuations are low. future returns are highest and vice versa. So:

PE = high, valuations are high and future returns are likely to be low
PE = low, valuations are low and future returns are likely to be high

Almost at definition this is true: at high valuations more money is required to generate a similar return. So if the valuation is 10, only 1 is required to generate a 10% gain. If the valuation is 20, it requires 2 to generate a 10% gain. The stock market can move rather quickly (investors can get carried away and bid up prices fast), but for the real economy this is different. The economy grows at 2-3% on average, it takes quite a long while to actually rise substantially.

Molodovsky-effect

The Molodovsky desribes the effect that earnings of cyclical companies decline in recessions. Analysts assum this is temporary so stock prices decline only a little. So its PE increases.

The valuation of cyclical companies increases in recessions. The valuation of defensive companies decrease in recessions.

Statistical tests

To study data, researchers use scatter plots and study regression. It helps them to better understand the data and to see if there is a credible relation between variables.

One metric used in the test is the R2 (r-squared). The higher the R2, the stronger the connection between the variables.

Time, not timing

The R2 of the Shiller PE and future stock returns is fairly high, but far from perfect. This means there are other factors impacting future stock market returns.

So the Shiller PE provides a clue about how cheap or expensive the market is. Not about whether it is a good time to buy or sell, right now.

Data and graphs:

Find the latest value here (multpl.com)
Or check this site for regional CAPEs (updated each 6m):

Important research

Before reading further: sometimes you find out that someone else has done something similar as we are trying here. Check out this excellent summary from Mebane Faber or Barclays: