Understanding the Shiller CAPE Ratio and the false narratives it has encouraged among investors helps put stock market risk in perspective

Dr. Robert Shiller—economics professor at Yale University, and joint winner of the 2013 Nobel Prize in Economics—has redeemed himself, in our opinion. I’ll say more in a moment, but first let me refresh your memory.

You’ve probably read about Dr. Shiller here and elsewhere, but not for his link with Yale or the Nobel. Instead, he captured investor attention by creating what he calls the Cyclically Adjusted PE Ratio, or “CAPE Ratio,” his own version of the P/E ratio. It’s better known as the Shiller P/E, as well as the Shiller CAPE ratio.

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 Shiller adapts the PE ratio

 Professor Shiller tried to improve on the P/E by adjusting the “E,” or earnings figures, downward for each of the previous 10 years for inflation, based on yearly changes in the consumer price index. He then averaged those 10 inflation-adjusted years’ earnings before using the adjusted figures to compute a long-term history of year-to-year changes in this “Shiller P/E” for the U.S. S&P 500 stock market index.

If you take the Shiller P/E at face value, it shows an extraordinarily high P/E ratio during much of the past five to 10 years, which suggests an exceptionally high level of risk. This squares with Dr. Shiller’s investment views in those years. In June 2015, for instance, he warned in an interview of the risk of a market crash. But no market crash occurred.

Don’t fall for the illusion of risk

In our view, the Shiller P/E was high due to a timing mismatch. Its “P” reflects current stock prices; the “E” is an artificially shrunken version of historical earnings.

The “E” in the Shiller-adjusted P/E is a running average of annual earnings in each of the past 10 years. This includes the disastrous earnings plunge of the recession of 2008/2009. This plunge was a rare occurrence—the worst recession and worst earnings slide since the 1930s. It qualifies as a once-in-a-lifetime event, not something you’d expect in the average decade.

To make things worse, the Shiller P/E discounts the last 10 years of earnings for past inflation—reduces each year’s earnings to reflect the inflation that has taken place since then, even if it only averaged a few percentage points a year. This deflates the “E” all the more, which balloons the P/E to exaggerated heights.

The Shiller P/E contributed to a false stock-market narrative that you’ve no doubt heard many times in the past few years: “The stock market has gone up too far/too long and is due for a steep downturn or bear market”. This common-place view seems to make sense, because it hints at having some statistical foundation.

As we’ve often pointed out, we see no reason to assume any natural restriction on how long a market can go on rising (or falling, for that matter).

Perhaps Dr. Shiller saw the impact his version of the P/E was having on investors, due to the boost it gave to the false narrative. Maybe that’s what inspired him to write his latest book, Narrative Economics: How Stories Go Viral and Drive Major Economic Events, which came out last month.

The book is a semi-scholarly work on economics and history, rather than a guide to investing. Dr. Shiller seems more interested in the origins and spread of narratives than the impact they may have on his readers’ investment decisions. He does give examples of how past narratives have influenced business investment decisions and economic growth.

Beware stock market false narratives

You’ll often hear the term “false narrative” in current U.S. political commentary. It refers to news stories that aim to leave people with a false or misleading impression about what’s going on in politics and government. Although the term is relatively new, the concept is old, especially in the stock market.

Alerting you to false narratives in the stock market is a key part of our work. After all, they can taint your view of the investment outlook, and lead you to make costly investment errors.

We always have a general idea of how the market is likely to behave over the next few years. Our ideas aren’t always right, of course. But many clients and readers say they are better off with our guidance than without it.

You can of course turn a collection of ideas into a narrative, by focusing on some ideas and ditching or downplaying others. When you do that, however, you run the risk of falling in love with the story you’ve created. This can put a filter on what you see and hear. You’ll tend to zero in on things that support your views, and fail to notice things that disagree.

Instead of gathering up a collection of ideas, we prefer to make two lists—one of positive factors for investment, another of negatives. You’ll often find cross connections between and among, the positives and negatives.

Understand P/E characteristics of Successful Investor stocks to add gains to your portfolio

Blue chip companies can give investors an additional measure of safety in volatile markets. And the best ones offer an attractive combination of moderate P/Es, steady or rising dividend yields (annual dividend divided by the share price) and promising growth prospects.

We feel most investors should hold the bulk of their investment portfolios in blue chip investments that follow our Successful Investor philosophy:

1. Hold mostly high-quality, dividend-paying stocks.
2. Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities.
3. Downplay or stay out of stocks in the broker/media limelight.

What investing tools do you find more helpful than the Shiller CAPE ratio?