The Shiller PE ratio gives investors a chance to understand the earnings cycle over time. It's a long-term measure, which makes it dangerous if you refer to it to make short-term investment decisions.
The Shiller PE ratio is one of the inputs investors use when assessing financial markets. This measure has recently hit the headlines as it has approached 2007 levels – the time of the last significant financial crisis. But it’s important to understand the Shiller PE ratio in context.
Another name for Shiller PE ratio is ‘cyclically adjusted price to earnings’ or CAPE. This measure smooths out the earnings cycle.
Typically, when a recession happens company earnings collapse. This makes share prices look expensive.
But the Shiller PE ratio gives investors a chance to understand the earnings cycle over time. It's a long-term measure. Which makes it dangerous if you refer to it to make short-term investment decisions.
So just because the Shiller PE ratio is at above average levels for the US at the moment, that does not give investors any information to guide thinking over the next two to three years.
Investors who want to use the Shiller PE ratio to make investment decisions need a 10-year time horizon. For self-managed super fund investors with a 10- 20- or 30-year time horizon, it might be one measure among many others to consider.
Using many sources
There are many other measures investors can take into account when making investment decisions. The equity risk premium is an example.
This is a comparison of earnings yields and bond yields. If you want to assess the market on a more short-term basis, the equity risk premium is a more useful measure than absolute valuation levels. This puts equity valuations in the context of the risk free rate and provides a better guide to shorter term cycles compared with long term absolute valuations such as the Shiller PE.
Aside from insights that inputs such as the Shiller PE ratio and risk premiums deliver, SMSF investors can explore other macro-economic factors and their potential to affect investment markets when making decisions about their funds.
Central bank actions over interest rates are an example. Inflation and real interest rates should also be taken into account.
In my team, we look at markets through these and various other lenses. Where we are in the economic and earnings cycle and market sentiment are other variables we take into account.
In terms of sentiment, at the moment investors remain concerned about whether the assets they own are right for them. It’s when investors become concerned about taking positions in asset classes they don’t own or when there is a widespread fear of missing out that risk in markets can rise.
As soon as investors start worrying about what they don't own and forget about the risks, it can be a bad time to invest. Expensive share prices, tightening central bank policy and heightened levels of euphoria in markets are also potential warning signs.
The idea is to understand the macro-economic as well as market valuations and use that to guide investment decisions.
Consider what’s happening in the US right now, price-to-earnings ratios are above average. The US market is also more expensive than other major markets.
Conversely, US company earnings growth is strong and even though the price of equities is slightly above the historical average, they could continue to rise in line with earnings. A relatively benign monetary policy environment should also be contemplated.
But other markets such as Europe and Japan are far less expensive than the US. Those markets have the potential for earnings growth and share market valuation re rating (that is, gains through both earnings growth as well as rising PEs). The value of US equities can continue to rise, but other countries’ share markets look like they have more upside than the US.
The lesson for SMSF trustees is not to take too much notice of short-term news, be objective not emotional when making decisions and ensure the method of analysis matches your time horizon.
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