The Shiller P/E ratio is an example of a single idea that is in fashion with investors, but out of tune with the current investment situation

From time to time a novel investment idea comes along. It may or may not have any lasting value. But it may still attract a following and gradually rise to its height of popularity. Often, it seems to hit that popularity peak just when it can do the most harm to its believers.

We think this applies to a novel investment idea that’s currently become commonplace—the Shiller price-to-earnings ratio or “Shiller p/e”.

The conventional per-share price-to-earnings ratio compares a stock’s price to its per-share earnings in a given year. It comes in two broad types. One concerns earnings estimates. This kind of p/e compares the current stock price to an estimate of future earnings—usually the current fiscal year, or the one after that. The other kind compares the current price to historical earnings—usually the last fiscal year, or the sum of the latest four fiscal quarters. The Shiller p/e is an extreme version of the historical type of p/e. It compares the current stock price to the average earnings of the previous 10 years.

The Shiller p/e is the creation of author, economist and Yale University professor Robert Shiller. Mr. Shiller used this ratio in his 2000 best-selling book, Irrational Exuberance. In that book, which came out within a month of the peak in the dot-com boom, Mr. Shiller showed how the ratio supported his view that stocks at that time were extremely over-priced. The timing of the book debut turned out to be perfect; the stock market began to swoon as soon as the book went on sale.

Mr. Shiller followed up with a 2005 edition of the book that applied a similar ratio to housing, comparing housing costs and individual incomes. He concluded that the U.S. was headed for a plunge in housing prices, which was just then getting underway.

The second book cemented Shiller’s reputation among academics and investment professionals. However, he became more widely known after being named a co-winner of the 2013 Nobel Prize in economics. This of course helped turn his Shiller p/e into a household term, at least in investing households.

Right now, the Shiller p/e is at its highest level in more than 20 years. Shiller p/e enthusiasts take this as a sign of high market risk. However, this may be a bad time to apply this particular ratio.

It made sense to apply the Shiller p/e in 2000, following a near-decade of extraordinarily profitable times for public companies. Exceptionally high p/e’s are a bad sign after a long rise in earnings—when the “e” or earnings number is high. But the past 10 years have been totally unlike the 1990s.

After all, the past 10 years include the financial crisis of 2007-2009. It was the worst recession since the Great 1930s Depression.

The past 10 years also include the weakest economic recovery since World War II. In fact, a recent study calculated that if the economic recovery since 2009 had been as strong as the average of the previous 10 economic recoveries that followed the end of World War II, 13.9 million more Americans would be working today. The average real per-capita income of every man, woman and child in America would be $6,308 higher.

In other words, unlike the 10 years prior to 2000, the 10 years before this year included a lot of years of exceptionally low earnings. This skews earnings downward. This pushes up the p/e.

Then too, all p/e ratios tend to be inversely related to interest rates. When interest rates are low, and they are extraordinarily low today, p/e’s tend to be high.

Mr. Shiller benefited from extraordinarily fortunate timing with the publication of his two books. However, both books contained views he held during the several years when he wrote the books and got them published. Shiller himself believes, as we do, that nobody can consistently predict future stock price trends.

The term “irrational exuberance” comes from a speech that Alan Greenspan gave in October 1996, when he was Chairman of the U.S. Federal Reserve Board. Mr. Greenspan used the term to describe his view of the stock market at that time. He felt it had gone up out of all proportion to the economic situation. Many economists agreed. However, the market kept on rising for nearly four more years.

It’s always a bad idea to base your investment outlook on any one indicator or tool. It’s a particularly bad idea to base your outlook on a single idea that is in fashion with investors, but out of tune with the current investment situation.

What stock strategy has proven useful to you? Have you ever sold a stock too quickly? Share your short-term investing experience with us in the comments.