The Shiller P/E ratio is a tool that you hear a lot of market watchers and analysts talk about and rely on, but for the average investors, it can be tough to figure out exactly what it is and what a high or a low Shiller P/E ratio means for them.
The Shiller P/E ratio is a price-to-earnings calculation made by taking a ten-year average of earnings (adjusted for inflation) and dividing that number by the current S&P 500 price. While it isn’t a really effective tool for short-term decision making, it can be quite useful for getting some market perspective and for calculating a reasonable range of expected returns. It does great over longer periods of time, helping to smooth out some of the volatility and peaks and valleys in the market to give you a better feel for where the market stands and where it might be going.
I’ve recently read a couple of interesting articles that suggest that where we might be going might not be all that pretty. These articles point out that the current Shiller P/E ratio is 25.4, up from 24 last August and more than 50% higher than the index’s historical average of 16.5. If you go back through time, you see an unmistakable pattern: the P/E ratio tends to peak right before major market crashes and periods of economic difficulty. The index reached its record high in December of 1999, just before the Tech Bubble burst, and its second highest ever reading was in 1929 (32.6) just before the Fall market crises that sparked the Great Depression.
The lesson to be learned here is that rapid expansion with sluggish earnings growth is foreboding. If the historical relationships hold—this may be more than just a small negative. I’d recommend that anyone who has significant assets in the stock market right now evaluate their exposure and, at the very least, keep a sharp eye on what happens to the Shiller P/E ratio in the months ahead.