Shiller CAPE Ratio

Hello folks,

For the uninitiated, CAPE ratio refers to "Cyclically Adjusted Price to Earnings" ratio; it is a valuation measure frequently used for the S&P 500. If you are unfamiliar with the S&P 500, this is an index that tracks the 500 largest companies on the New York Stock Exchange (NYSE). Here, we are thinking of Apple, Home Depot, Visa, UnitedHealth Group, Amazon, Google, Tesla, and others.

Before we move forward, let’s pause and briefly introduce Robert J. Shiller, and why he’s important. Robert James Shiller won the Nobel Prize in Economics in 2013, and he wrote a New York Times Best-Seller called Irrational Exuberance. His Nobel prize was awarded for the empirical analysis of asset prices, which he shares with Eugene Fama and Lars Peter Hansen. He is the inventor of the CAPE ratio, which is a metric commonly used by investors. Shiller (lord, forgive me for the puns I’m about to make) isn’t some internet shill trying to sell a non-evidence based, stock market investing course on TikTok and YouTube; he received a PhD from MIT and teaches at Yale University.

The Shiller CAPE is calculated by taking the price and dividing by the average of ten years of earnings, adjusted for inflation. It is used to assess future returns from equities with higher than average CAPE values implying lower than average long-term returns. What does this mean in simpler terms?

When the CAPE is high, equity returns are expected to be low and vice versa.

Mandeep, what are equities?

Here, when I say equities, I am referring to stocks.

You might say, "The economy in the US has matured and we’re sitting at really high Shiller CAPE ratios. Surely, there is not much room for US stocks to grow."

Is this the right way to think?

Essentially, what you are saying is there isn’t room for further innovation here in the US. In my opinion, this is false.

Let’s rewind time and look at an example.

Life was good in the 60s and 70s in the US as birth control, touch-tone telephones, washing machines, and dishwashers dramatically improved the life of the average American.

Let’s say you were an American during that time. You might have thought, “Man, life is really good right now. How could it possibly get any better?” The stock market is too expensive, you say.

You would have lost out on the amazing bull run the market has had since then. By not participating in the market, you would have lost out on a metric ton of money.

More importantly, the internet hadn’t become a mainstream product because it hadn’t been invented yet, which occurred in 1983. Computers were not commonplace. These two things have absolutely revolutionized all of our lives. The players sitting at the top of the S&P 500 are tech companies.

That American in the 60s was thinking life couldn’t get much better, but he or she was wrong. Is it possible that this position might be wrong today?

Absolutely.

American innovation will continue to thrive as we move forward with artificial intelligence, neural networks, and machine learning at the helm. This is not to say you shouldn’t invest in low cost, international index funds like VTIAX.

"The Bogleheads’ Guide to the Three Fund Portfolio" actually recommends a 80%-20% split between US and international stock market index funds, respectively. However, when investing in international index funds you also have exposure to regulatory risk. This means the government may meddle in the business segment of developing countries in an international stock market index fund. Secondly, most of the companies sitting at the top of the S&P 500 are multinational companies, meaning they do business outside of the US in other countries. Some find domestic diversification, US stocks, to be satisfactory.

You might say "I want to bet on the 5 or so large tech companies at the top of the S&P 500 - Google, Microsoft, Apple, etc." Maybe the FAANG stocks - Facebook (Meta), Apple, Amazon, Netflix, and Google?

Let's take a look at the S&P 500 in 1980.

Some of the top companies by market capitalization, in order, are IBM, AT&T, Exxon, Standard Oil of Indiana, Schlumberger, and Shell Oil.

You’ll notice these companies are not present today in the top 10 positions of the S&P 500.

What does this mean?

They fell out of the top.

Is it possible Google has a place at the top since it has several assets, including a subsidiary called DeepMind? Maybe. But for how long?

Amazon has Polly, Sage-Maker, and other assets that we know of in the public domain and several in the private domain that we know nothing of.

Is it possible Google will retain its position or perhaps buy out those developing innovative new tech? Maybe.

Is it also possible that another competitor will displace them just as they did to their predecessors? Yes.

So wouldn’t it make sense to just buy the S&P 500 instead of betting on individual tech stocks (or “disruptive funds” - looking at you, Cathie Wood)? Absolutely! This is the high percentage winning strategy here, and personally this is the way I go.

Actually, I bet on a wider pool under VTSAX, which is the Total US stock market index fund from Vanguard.

Let’s revisit the Shiller CAPE ratio and take a look into the past.

In the late 1990s the CAPE was close to 25, a near all time high. It was fast approaching the last all time high - Black Tuesday, where the CAPE was 30.

You might have thought, "Stocks are overpriced - sell, sell, sell."

However, the CAPE climbed all the way up to 45. You would have sold too early before everything came crashing down. If you sold early or did not invest into the stock market, you lost a tremendous amount of stock market gains.

The old adage holds true. Time in the market beats timing the market. In my opinion, there are only a few strategies to employ in the contribution phase; these are your working years where you are building a nest egg.

My strategy is as follows:

1. Buy index funds.

2. If the Shiller CAPE is at an all time high... buy index funds.

3. What if there is a huge stock market decline? Buy MORE index funds.

You might see a common theme here (buy index funds), and you might also realize I never sell index funds.

It might be useful to adopt the mentality of the Reddit r/wallstreetbets GME Superstonk Apes.

Have diamond hands and don’t fold.

The best course of action is to stay the course. Perhaps, there’s some extra juice to squeeze from Fama/French Factor Investing or the Small Cap Value story, but that's a conversation for another time.

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Disclaimer: The article above is an opinion and is for informational/educational purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice. The author has taken care in writing this post but makes no expressed or implied warranty of any kind and assumes no responsibility for errors or omissions. No liability is assumed for incidental or consequential damages in connection with or arising out of the use of this information.