What A High Shiller CAPE Ratio Means For Investors

When we talk about overvaluation in the stock market, the Shiller CAPE ratio often comes up. Unlike many other valuation measurements, the Shiller CAPE ratio is based directly on earnings. A high Shiller CAPE ratio implies a low earnings yield. With stocks as with bonds, low yields eventually lead to low returns.

In the bond market, the bubble is easier to see. We knew early last year that a 30-year Treasury bond was only going to earn about 3% each year. The Fed cut rates, so there were big gains for bondholders. Unfortunately, those gains mean lower returns in the future. In 2020, 30-year Treasuries are guaranteed to return less than 2.5% per year. That’s all there is to it.

Real estate is still a better long-term investment than bonds, but there are limits even here. A house costing $240,000 might rent for $1,200 per month, which means that it yields 6% per year in rent. Unlike bonds, the price of the house will keep up with inflation in the long run. On the other hand, you will have to pay for repairs. However, the logic remains the same. Housing prices went up over the last decade, rents did not keep up, and expected returns fell.

Stocks are really no different from bonds or real estate. Stocks are companies, and successful companies ultimately have to earn money. This money can go to the shareholders as dividends, or the firm can reinvest it in the business. In any case, the earnings are the real source of long-term gains for stockholders. Earnings for stocks are just like rent for real estate.

A simple approach to estimating the earnings yield would be to divide the earnings per share by the price of the stock. In the real world, corporate earnings fluctuate dramatically from year to year. During the 2008 Financial Crisis, earnings fell over 75%. Earnings also tend to be higher during booms, so averaging them over the last ten years is a better approach. 

The Shiller CAPE ratio is the inverse of the 10-year average earnings yield described above. The Shiller CAPE ratio was about 31.5 in early 2020, so dividing 100 by 31.5 gives us the earnings yield. The earnings yield for the stock market is about 3.17%. In theory, it would be rational to expect stocks to return just 3.17% per year going forward. In reality, returns will probably be lower. That’s because overpriced stocks tend to crash. Permanently high plateaus exist only in theory.

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