Jul 09, 2014 | Post by: Roman Chuyan, CFA Comments Off on Is Shiller’s P/E a Good Measure of Market Valuation?

Is Shiller’s P/E a Good Measure of Market Valuation?

Many observers are puzzled by the equity market’s continued strength. Some predict negative outcomes this year, citing the length or strength of the rally or high valuation. Yale university professor Robert Shiller – author of the book Irrational Exuberance –recently appeared in financial media citing (once again) the high level of his 10-year average real P/E ratio (known as “Shiller’s P/E”) as a reason to be concerned about equities.

However, Shiller’s P/E has significant limitations that render it unsuitable for tactical investment management. Its primary shortfall, in our view, is its severe lag due to using 10-year average earnings, such that depressed 2008-09 earnings are still included in the “E.”

It is also often misused as a predictive factor of near-term equity index returns for tactical management. Prof. Shiller didn’t stipulate this in his book – he linked his P/E measure to subsequent 20-year average equity market return (which will be known in 20 years), not to near-term return. According to our analysis, Shiller’s P/E is not a very accurate predictor of near-term returns.

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