New York Stock Exchange

Recently, I got a call from a physician client of mine who asked a fantastic question. The Shiller PE of the S&P 500 index is at 24 now, much higher than the historical mean of 16 – is the market headed for a fall?

What is the Shiller PE?

This is a stock market metric invented by Yale Professor Robert Shiller. Basically, it is the average of the PE ratios of ten consecutive years. Because of that, Shiller PE is also called PE10.

Professor Shiller found it to be a reasonably good measure of valuation of the whole market: the higher the Shiller PE, the more expensive the market.

Back to my client’s question, I told him right away that I don’t know the answer. I don’t make investment decision based on opinion. I have to research historical data. After I hung up the phone, I asked my assistant to study the relationship between the Shiller PE and forward one-year and forward three-year returns.

Here are the results (scatter plots):

Fig. 1: Forward one-year return vs. Shiller PE

Fig. 2: Forward three-year return vs. Shiller PE

Here is what I learn from the plots:

1. The higher the Shiller PE, the lower the one-year and three-year returns.
2. Return variability was so high as to render the Shiller PE’s predictive power very weak.
3. Only when Shiller PE is over 35 are the three-year forward returns overwhelmingly negative.

So after much research, I can answer my client’s question. No, the market is not headed for a fall, but we do need to lower our expectation of future returns.

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