The famous Shiller PE ratio is once again at the centre of much debate.
The measure — which is based on 10-year, inflation-adjusted earnings — indicates that stocks are once again extremely overvalued.
Detractors, like BofA/ML’s David Bianco think the measure is useless because the Shiller number is distorted by writeoffs, and compares apples to oranges (stocks pre-and post-war, basically).
For investors, what matters is not whether stocks are “overvalued” or more expensive than they were in history, but whether using the ratio can actually make you money. In other words, should you sell when the ratio gets to high?
Anwiti Bahugana, Ph.D and Tom West of Columbia Management has run the numbers on this question, and their conclusions are interesting:
A general rule of investment proclaims that one must buy low and sell high. We tested this hypothesis using Shiller’s P/E as a guide for market’s cheapness. Using data from 1872 onwards, we ranked ordered P/Es and divided them into valuation quintiles. The most expensive quintile had valuations of more than 19x and the cheapest quintile with valuations less than 10x. As expected, buying stocks when valuations are the cheapest does indeed provide the best returns over the next 10 years. However, buying stocks when they are in the two uppermost (i.e., expensive) quartiles also returns about 6-8%. Results are about the same when we look at returns over the next 12-month period. Average returns are about 6% and median about 8%.
Here’s their table:
This is a bit unsatisfying, but the general conclusion you could take away from this is… yes, it’s better to buy stocks when they’re “cheap” but at least historically, it hasn’t made sense to sell stocks when they’re expensive.
Stocks may be due for a tumble here, but the Shiller Ratio alone isn’t enough.