Background

The Shiller P/E ratio for the S&P 500 equity market index is based on average inflation-adjusted earnings from the previous 10 years, and is also known as the Cyclically Adjusted PE Ratio (CAPE Ratio). As such, it is principally used to assess likely future returns from equities over timescales of 10 to 20 years, with higher than average CAPE values implying lower than average long-term annual average returns.

The ratio is used to gauge whether the stock market is undervalued or overvalued by comparing its current market price to its inflation adjusted historical earnings record.

Using average earnings over the last decade helps to smooth out the impact of business cycles and other events and gives a better picture of the market’s sustainable earning power.

It is not intended as an indicator of impending market crashes, although high CAPE values have been associated with such events.

How is the Shiller P/E Calculated?

1. Use the combined annual earnings of the S&P 500 companies over the past 10 years.
2. Adjust the past earnings for inflation using the consumer price index.
3. Take the average of the earnings for the past 10 years.
4. Divide the combined market cap the S&P 500 index with the average earnings for the past 10 years.

Current and Historic Level of the Shiller P/E Ratio

In the below chart we have depicted the Shiller P/E ratio since 1990. The chart is updated daily.

Critique of the Shiller P/E ratio

While the Shiller P/E without doubt deals with a lot of the pitfalls of the 12 months trailing P/E ratio it is by no way a perfect measure of market valuation. Below is listed some of the key criticisms raised in regards to the Shiller P/E ratio:

• Most businesses are different today than they were ten years ago or even five years ago. They also operate in different markets with different market conditions, different regulatory situations and in different countries.
• Various accounting standards today are different than ten years ago.
• P/E ratios are higher today in part because interest rates are on a secular downtrend. Lower rates all else equal lead to higher P/E ratios.
• Demand for stocks has increased dramatically. There is much more cash looking for an investment. Over the past ten years the amount of money in mutual funds, hedge funds, ETFs, insurance companies, 401Ks and sovereign funds have surged. Meanwhile, supply has decreased. as there are fewer listed stocks in the U.S. than there were ten years ago.
• The Shiller P/E ratio does not adjust for changes in dividend yield which has been lowered in part by lower interest rates.
• The Shiller P/E ratio is used in part to determine when to position for reversion to the mean. However, the mean is changing.

How Does Sensa Investments use the Shiller P/E?

The Shiller P/E is one of the factors used in our investment algorithms (read more about our approach here). While we fully acknowledge the shortcomings of the ratio our experience based on extensive research has shown that the ratio is helpful from a risk management perspective both in terms of implied leverage and in setting target delta levels for the option positions in our products. Our algorithms are thus (amongst a number of other factors) optimised from a risk adjusted returns perspective by adjusting leverage and delta levels based on the prevailing level of the Shiller P/E.