What is the Shiller P/E Ratio?
When discussing the Shiller P/E ratio we first have to discuss a typical P/E ratio. A normal P/E ratio is simply Price divided by Earnings. This is calculated by taking the current stock price and dividing it by the reported aum of the last four quarter's worth of earnings per share.
Take Apple for example:
EPS over the past year has equaled $6.04 (per qtr earnings of $2.10, $1.24, $1.30, and $1.40). Their current price as of 4/1/22 is $174.61.
$174.61 / $6.04 = P/E ratio of 28.9 (of course this number is readily available on just about any financial quote page)
Okay, so that can be useful. However, that number does have its drawbacks when trying to draw any sort of long-term conclusion. The P/E as a standalone indicator is problematic, however. For instance, a company may have a low P/E and appear undervalued, but closer inspection might show that it is buried in debt that it can't service, and is close to going under. A similar company might have a much higher P/E, but be a better investment due to having no debt, loads of cash, and substantial YoY earnings growth.
That said, P/E is worth a peek, but nobody should be trading off of this number alone.
The Shiller PE Ratio is different. The Shiller takes 10 years of Price and Earnings into its calculation, and also adjusts them for inflation. This smooths out the PE and gives us a better understanding of where things are from a more historical perspective.
The Shiller isn't used so much on individual stocks (though it can be), but is instead used as a sort of benchmark for investors, being focused mainly on the S&P index as a whole.
The chart below is updated constantly here: Shiller PE Ratio
The historical average of the Shiller PE Ratio is about 15. The current ratio is nearly 37.
You can see in the chart that the Shiller PE is at the second highest point in history, behind only the dotcom bubble. It is telling us that historically, stocks are expensive right now. Unfortunately, while the Shiller does a good job of predicting long-term returns, it is pretty horrible as a timing tool. In hindsight, of course, it looks great at timing. Just sell at the top, right?
But where is the top? If the historical average is 15, should you think of 20 as the time to sell? 25? 30? There have been times when any of these would have been good, but there have been many times when the bull markets would have continued on relentlessly without you if you had sold out based on the Shiller alone.
When trading individual stock charts we often look at the 200-DMA to give us an idea of how "stretched" a stock is. Eventually it is going to snap back to the 200, so if it is already far above the 200 when you buy, you know to be a bit more cautious and be ready to close out quickly if the turn lower comes. If the stock is well below the 200, it can similarly be a good indication that a bottom is near.
The Shiller can be used in much the same way for an overall market view. Right now, stocks are "stretched." That doesn't mean they can't get more stretched, they can—you only have to look back to 2000 to see that. If you simply closed out your investments and went to cash now you could end up missing another one, two, five years of upside stretching.
A better idea is to use the Shiller as a cautionary indicator. Be aware that by historical measures stocks are priced very high. Be prepared for an event, or series of events, that conspire to snap it back to the average. It won't happen today, it probably won't happen next week, but eventually it will snap back. It always does. If you are aware of the possibility, and the reasons behind it, you'll be better prepared to react when it does.
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