The 20th-century average Shiller P/E ratio is 15.21. In November 2014, the number is 27.1. To put that in perspective, since 1881 the ratio has only gone past 25 in three other periods… the years surrounding 1929, 1999 and 2007. We all know what happened after those market peaks.
If you believe in reversion to the mean, it isn’t difficult to understand that stocks won’t stay at this high forever. In his book, Irrational Exuberance, Shiller explains the psychology behind market bubbles, such as the ones from 1929 and 1999. Bubbles are led by unsustainable investor enthusiasm and eventually they pop.
Shiller explains that his P/E ratio was never meant to indicate timing on when to buy and that stocks could be at these valuations for years. However, investors should proceed with caution.
In his commentary in The Intelligent Investor, Jason Zweig writes about Shiller and the ratio, explaining that when it goes well above 20, the market usually delivers poor returns afterward. Likewise, when it goes below 10, stocks typically produce decent gains later. It’s appropriate to mention that Shiller says Ben Graham inspired his valuation approach, which makes sense, figuring the Shiller P/E is a way to tell investors if the market is overvalued.
In November 2014, the Shiller P/E should serve as a yellow light for investors. Yes, it is climbing higher and higher above the historical mean, but it’s still below the 1999 peak of above 44.
Adjust your investment style accordingly, remain informed and stay the course!