hi I'm Jimmy in this video we're gonna walk through the Shiller p/e ratio this
is also known as the Cape ratio Cape is short for a cyclically adjusted price to
earnings ratio the goal of this video is to understand what the Shiller p/e ratio
is how it looks today and how we could use it to make better
investment decisions okay let's jump right in so this is a charter of the
Shiller p/e ratio going all the way back to 1920 and the theory here is that we
can use the level of the Schiller p/e ratio to determine if the market is
overvalued or undervalued and it's supposed to guide us as to whether or
not returns over the next 10 years are supposed to be above average or below
average and that's we're supposed to be able to determine that based on the
current level of the Schiller p/e ratio so how does it work well if we think
about the traditional price to earnings ratio it's generally quite simple we
take the current price and we divide that by the earnings per share generally
those earnings per share are the earnings over the past 12 months and
that gives us the traditional price to earnings ratio and ideally we want to
buy a stock when the when it has a lower p/e ratio since this would mean that
we're paying a lower price for more for more earnings so if the Schiller p/e
does is it takes the average earnings from the past 10 years and it uses that
in the very same formula so what it really does is it does a better job of
eliminating for dramatic effects of any one quarter or one annual report another
way to look at it is that this sort of smooths out the earnings but show the
Shiller P/E doesn't stop there they took this one step further they also adjust
these earnings based on the inflation rate so instead of ten years of average
earnings they end up with ten years of average real earnings and just so we're
on the same page whenever they put the word real before earnings or returns or
anything like that it's just a way of saying that that number has been
adjusted for inflation so if you told me that my return last year was 10% and
that my real return last year was 8% well without you telling me any more
information I can safely assume that inflation was
about 2% last year so why does this matter for the p/e ratio well imagine a
company was growing by the same 2% every year and pretend inflation was also 2%
every year well the company isn't really growing at all they're really just
letting inflation carry them along so by adjusting earnings by inflation what we
should end up with a cleaner look at their numbers and to clean a look at the
value they bring in the long run so if we switch back to this chart and just so
we just so we're clear this is a chart of the S&P 500 Shiller has come on said
that he thinks this is best suited for the S&P 500
typically not applied to companies you could do it but most of the back testing
has been applied to the S&P 500 so the assumption is that with the Shiller p/e
ratio the s&p 500 will revert to the mean p/e ratio which basically means that
eventually the ratios will fall back to the average Robert Shiller's data
the man who created this index well his data went all the way back to 1871 and
the average for 1871 till now is about 17 which is what this line right here is
and if you're curious where I got this information
I got it directly from Yale University's website which is where Robert Shiller is
a professor and he updates that every month
the most recent up-to-date number that we have was as of December of 2019 I
don't have January's numbers yet so I just took that data straight from the
Excel spreadsheet that he provided then I created these charts so in theory
anything above this Green Line is supposed to indicate weaker performance
over the next ten years anything below the Green Line is supposed to indicate
that there will be better performance of the next ten years clearly when the
Shiller p/e ratio got above 30 back here and this was back in 1929 well if we
were to zoom into the 20s and 30s and then we would add the S&P 500 to this
well the S&P 500 is the orange line the blue bars or the Schiller p/e ratio well
back when the SP 500 was near its peak at the top of 1929
clearly the Shiller p/e ratio was calling for huge underperform
over the next 10 years and we know that because they show a PE ratio at that
time was way above the average and we could see that that is did in fact
happen then when we jumped forward the next 20 years this is the 40s and 50s
well here the Shiller p/e ratio spent much of their time below the long-term
average and if we bought the S&P 500 when the Shiller P/E was below 10 while
the Shiller P/E was correct the next 10 years turned out to be quite true same
is true back in 1950 going on to 1960 so clearly this is holding up now if we
jump forward again the next 20 years if we bought down here on the Shiller p/e
ratio was high in 1966 well we can see that it is once again true the
investment would have underperformed now that would have dependents somewhat on
what we bought or when exactly we bought and went exactly what we sold I sort of
put it in a straight line here but I think it's safe to say that we would
have underperformed the average knowing that in ten years time we would have a
zero percent return that sounds like an under performance doesn't necessarily
have to be a down performance okay now this is where it gets interesting
now we're jumping to the 80s and 90s right up to the year 2000 now clearly if
we bought in 1980 when the Shiller PE was low below 10 in this case well the
S&P 500 did in fact do great over the next 10 years moved from about 200 to a
bit more than 400 sure that doesn't look like a lot on this particular chart
because of how high this scale actually went but that's a double over 10 years
which is decent now it gets a bit more interesting so in 1990 it seems that the
Shiller p/e ratio is right around the average level and clearly the returns
were anything but average now if we're curious Robert Shiller did his study of
this particular of he introduced the Shiller p/e ratio back around this time
period when the Shiller p/e ratio had just crossed above 30 and at that time
he said that this was the first time was above 30 since 1929 and therefore he saw
a crash coming in the not-too-distant future and we can skip ahead to the next
chart where we can see that he was right that's what happened that's when the
tech bubble crash now a very high Shiller p/e ratio at the
start of the year 2000 led to poor performance over the next 10 years
partially and thanks to both the tech bubble and then the Great Recession and
a Shiller p/e below our average line which is what happened down here well we
can see that this was the bottom of the Great Recession and it did in fact lead
to great performance over the next 10 years but what about here well the
Shiller p/e ratio was above the long-term average again and clearly things have
done quite well since 2010 so that's one of those examples where it hasn't
exactly worked out that way and we could see that since the Great Recession the
Shiller p/e ratio has been consistently above the average now we can't say with
certainty that this means that the Shiller p/e ratio is wrong it is
designed to give us long term information in theory out ten years plus
but the question that I found myself asking was if we avoided investing
whenever the Shiller p/e ratio got above the long-term average we would have
missed out on the greatest bull run in history at least in the United States so
in my mind the Shiller p/e ratio is a very useful tool I don't think it's the
end-all be-all I don't think it's the final decision-making tool it's a tool
that we can use to perhaps consider how defensive we are with our investments
even Robert Shiller has said that he chooses to focus on value investing and
that he uses the Cape ratio which is the same as a Shiller ratio well he uses the
Cape ratio to help him decide how over or undervalued the market really is at
that particular time now I do think it's important to point out that these
numbers for the S&P 500 are price returns that don't include dividends and
dividends have proven to be better performers during a stock market crash
and mostly in the aftermath of a stock market crash they're generally the first
stocks to recover so for worried about a clearly high show a p/e ratio right now
well I recently did a video where I go through some good monthly dividend
paying ETFs and if you're curious that could be a good next video
if you're looking for some good investments that could perhaps be good
investments over the long term I get a link right here and got a link in the
description below and I want to thank you for stick with me all the way into
the video I really appreciate it thanks and I'll see in the next video