A lot of attention has been given to the Shiller P/E ratio lately. The Shiller P/E, or cyclically-adjusted P/E (CAPE), isn’t based on last year’s earnings or forecasted earnings. Instead, it uses average inflation-adjusted earnings from the last 10 years in its denominator. This is meant to “smooth” earnings over the business cycle.
Based on this metric, the S&P 500 is trading at 25.3x, placing it in the top 10% most “expensive” CAPEs going back to 1926.
While the CAPE historically does a poor job of predicting short-term market returns, its predictive power improves the longer the time horizon gets.
A study by Cliff Asness of AQR Capital Management in 2012 divided CAPEs up into deciles and looked at their 10-year forward average real (inflation-adjusted) returns. Here were the results:
You can clearly see that the higher the CAPE, the lower the future returns for stocks. For CAPEs in the top decile (like we are now), the average real 10-year return was a measely 0.9%. The returns varied, of course, but even the best 10-year average real return was just 6.3% for the highest decile while the worst was -6.1%.
What do you think of this chart? Will the fact that the cyclically-adjusted P/E ratio is high change your asset allocation at all?
Let us know. Chime in below!