Shiller S&P500 P/E RatioBrief Description About the P/E Ratio
The p/e ratio is the price of a share of a stock divided by the earnings per share, so it’s the earnings that the company makes during a year divided by the number of outstanding shares. Once calculated the answer is a multiple. This is one of the best valuation metrics that investors have been able to use to judge whether they’re buying an overvalued or an undervalued stock.
Using the logic of this fundamental indicator for individual stocks, Dr .Robert Shiller applied this to the S&P 500 , using the S&P 500 as a general gauge of the entire stock market. By doing this, it allowed us to see whether the stock market is undervalued, fair valued, overvalued, and in a bubble, etc.
About the Shiller S&P 500 P/E Ratio
The Shiller p/e ratio is slightly different from the traditional S&P 500 p/e ratio where; instead of dividing by the earnings of one year, this ratio divides the price of the S&P 500 index by the average inflation-adjusted earnings of the previous 10 years. The ratio is also known as the Cyclically Adjusted PE Ratio (CAPE Ratio), the Shiller PE Ratio, or the P/E10.
Areas of the Shiller S&P500 P/E Ratio
As you can see on the chart, there are several different ranges with each one describing the "state" of the stock market
0-5 = stocks are extremely undervalued
5-10 = stocks are undervalued
10-15 = stocks are at fair value
15-20 = stocks are overvalued
20-30 = stocks are in a bubble
30-40 = stocks are in an extreme bubble
Interpreting the Multiple
Think of the multiple this way; you are paying (insert multiple number) times the earnings . Another way to interpret the multiple, it can be counted as the number of years it would take for the individual to get his investment back.
Example #1 : Great Depression, one of the worst times in history, the Shiller S&P 500 p/e Ratio was above 32.56, this means you are paying 32.56 times the earnings , and it would take the investor 32.56 years to get his investment back.
Example #2 : 1998-2000 the Shiller S&P 500 p/e Ratio was 44.19, this means you are paying 44.19 times the earnings , and it would take you the investor 44.19 years to get your investment back, even if they were to give you all of the earnings as dividends you would still have to wait 44.19 years.
That’s insane, that is a lifetime!
“Timing beats speed, precision beats power”
Analyzing the Shiller S&P 500 P/E Ratio
One thing you will notice when doing some analyses of this multiple is the following: whenever the multiple surpasses the 20-30 area, the multiple always returns back to 0-10 area. Once the trend reverses and the bubble pops, it doesn’t stop until the multiple has reached some somewhere in the range of 0-10 (undervaluation) as I have illustrated above with the blue arrows. It does this without exception. It would need to revisit undervaluation before a new “healthy” real bull market were to start again. Once the trend has reversed it doesn’t go straight down, it mimics the movement of a ball rolling down the stairs. You can think of each step of stairs as one of the areas it has to go through before eventually reaching the bottom, similar to how the Fibonacci retracement tool works.
Using this historically repeating pattern, I'd say we are currently on another step down the stairs before we eventually make our way down the bottom of the stairs where we revisit undervaluation areas.
Once have reached the undervaluation areas, this will also be a moment of consolidation where investors, traders, pension fund managers, self-directed IRA owners will have most likely given up and have thrown in the towel. You will most likely see news article titles saying something along the lines of: to invest into the stock market is one of the worst things you could do, but it couldn’t be further from the truth. You can apply this reasoning to all the different kinds of markets and remember these...
"When the time to buy comes, you won’t want too"
"Buy when there’s blood in the streets, even if the blood is your own"
Why has the the multiple so high over the past 20 years or so, well at least why I think it is high
These are some explanations came up with
1 - Interest Rates are Low
Specifically the "Interest Rate - Investment" graph
For those who have taken macroeconomics in college or university, etc know about this graph. Essentially the idea/theory behind this graph is that investments change according to interest rates.
High interest rates = fewer "projects" approved
When interest rates are high, and people want a good return on their investment what do they buy? People buy bonds, not cash, because cash
doesn't earn interest. By having high interest rates, money is "expensive", it isn't readily available. High interest rates = slower economic growth .
Lower interest rates = more "projects" approved
When interest rates are low people are going to do the exact opposite of holding bonds, they are going to hold cash, because the rate of return
is low enough to not put their money in a locked contract for a specified time frame. When interest rates are low, money is "cheap", it is more
readily available. Low interest rates = fast economic growth.
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2 - Bond Yields are Low ---> Stock Market
The second reason here ties in with the first one. When interest rates are low, bond yields are low, thus no where else for money to go, except the stock market, the money will flow elsewhere, it will flow to other parts of the economy where investors can get a higher rate of return on their investments compared to the rate of returns of bonds. Buying a bond forces you to be in a locked contract for a specified period of time, with interest rates varying. Whereas, in the stock market there is no locked contract, you have more mobility, very high amounts of liquidity, more mobility and freedom to do as you wish with your money.
Example: say you bought some 10 year US bonds in January 2000, you would be getting somewhere around high 5%-mid 6% on your investment, but remember this contract is for 10 years, your locked in for 10 years, can't move out. Instead of buying 10 year US bonds and getting on average 5-6%, you invested in the stock market (ex: SPY ) you would be getting more, about 7-10% on your investment. Which is more logical?
Bond yields have been dropping from the beginning of the millennia, you can see that from around 1998-present time (link below).
stockcharts.com
These are some explanation I was able to come up with and why I think the multiple has been so high ever since the beginning of the millenia or so, I might be wrong, I might be right, don't really know, but thought i'd just put it out there, that others may see this and can get the gears turning.
Hope you enjoyed the post!
