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When a Good Indicator Goes Bad

The Shiller CAPE ratio.

John Rekenthaler, 12/18/2013

For more than a century, from 1880 through 1990, the stocks making up the U.S. market could be purchased for roughly 15 times the amount of their average annual corporate earnings, as measured over the previous decade. That is, if the companies making up the stock market generated an aggregate of $2 trillion in net profits over the past 10 years, thereby posting average annual earnings of $200 billion, then stock market capitalization was probably around $3 trillion. The ratio wasn't fixed and immutable--it might be higher so that stocks cost $4 trillion, or lower so that they were $2 trillion. But they were very unlikely to be as high as $5 trillion or as low as $1 trillion.  

This ratio, that of stock market capitalization to companies' average earnings, became known as the Shiller CAPE ratio. Since the mid-1990s, when it was introduced by Shiller, it has served as an informal measure of stock market value. When the Shiller CAPE figure is well above its historic norm, stocks are said to be expensive. Stock returns over the next few years will likely be low. If, on the other hand, the Shiller CAPE ratio is unusually low, stocks are thought of as cheap and therefore poised for good performance.

It's easy to see why people believed this when looking at the picture, particularly when considering that the big blip to the right (more on that shortly) occurred afterthe publication of the thesis. 

In the first 110 years of the data set, only six times did the Shiller CAPE ratio exceed 23 or fall below 7. The indicator went high in 1900, in the late 1920s, and then again in the early 1960s. Each period was followed by rocky stock market performances. It went low on three instances as well, in 1920, 1932, and in the early 1980s. The 1932 signal was premature, but 1920 and the early 1980s were terrific buying opportunities, being the start of huge market rallies.  

These insights, however, came in hindsight. Even as professor Shiller first released his research, in 1996, the 110-year pattern was changing. At that time, the CAPE ratio had hit 25--a level that previously had led almost immediately to a market slide. On this occasion, though, stocks kept rising, more than doubling over the next four years.

Eventually, from 2000-02, the bear market did arrive, as predicted several years previously by the Shiller CAPE ratio. That wasn't a helpful call. Yes, from the time that the indicator crossed its high band in 1996 to the time of the 2002 market trough, stocks had below-average results. However, moving the end date by one year in either direction increases the stock return to average, and moving the end date by two years leads to strong results. There was nothing in the CAPE ratio to indicate when end points should be used.  

The CAPE's informativeness did not improve. After showing stocks to be overpriced at the 2002 market bottom, the CAPE ratio was not particularly prescient in foreseeing the 2008 market crash. True, the ratio was elevated entering 2008--but it had been similarly elevated for the previous five years. 

Then, after showing a brief neutral signal in 2009, the CAPE measure promptly went negative again, early in the current bull market.  

is vice president of research for Morningstar.

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